Getting a mortgage involves a lot more than just filling out an application and waiting for approval. Your lender is going to assess your financial profile in great detail, and several factors come into play that determines whether or not you’re able to get approved for a mortgage.
One of the more important factors that lenders will consider before agreeing to extend a home loan to you is your debt-to-income ratio (DTI). this seemingly unassuming little number plays a key role in whether or not you can secure a mortgage.
What is a Debt-to-Income Ratio (DTI)?
Your ability to make your mortgage payments every month will depend on how much money you make. Obviously, your income will play a role in whether or not you can afford a mortgage, and therefore whether or not a lender will approve your application.
But the amount of debt you carry also comes into play. You might make a decent living, but how much of that income is dedicated to paying down all of the other debt that you currently hold? It’s quite possible that you’re nearly maxed out on all of your other debt payments and may not have enough left over to support a mortgage payment on top of it all.
A debt-to-income ratio is a representation of your debt relative to your income. More specifically, it’s calculated by dividing your monthly debt obligations by your monthly income.
For instance, if you are currently responsible for making $3,000 in debt payments every month and your income is $5,000 monthly, then your debt-to-income ratio would be 60%.
How Does Your DTI Play a Role in Mortgage Approval?
What your DTI tells lenders is how strapped you are in terms of other debt obligations and how much money you have available from your income that could be dedicated to paying a mortgage.
Keep in mind that the ratio originally calculated above does not take an additional monthly mortgage payment into consideration. If your DTI is already quite high without factoring in a mortgage payment into the equation, odds are you’d find it extremely difficult to cover mortgage payments on top of everything else you’re trying to juggle.
In turn, your lender is probably not going to be too confident about loaning you any money for a mortgage if you’re already maxed out on other debt obligations.
For instance, if your DTI is already at 60%, adding a mortgage payment into the mix will make it even higher. Even just a low $1,000 mortgage payment would send your DTI up to a whopping 80%.
Basically, lenders look at your DTI ratio to determine your ability to pay a mortgage. Ideally, the number should be low, as a lower number reflects lower debt loads and higher incomes, which is the ideal combination for mortgage approval. The higher your DTI is, the more likely you would be to default on your mortgage.
Generally speaking, lenders like to see a DTI of no more than 36%. In the example illustrated above, a DTI of 60% would be considered quite high. With a DTI that high, lenders would be more likely to reject your mortgage application because you would be considered too much of a risk.
Even if you were approved for a mortgage, your interest rate would likely be higher compared to a borrower with a low DTI. The reason why a higher rate would be charged is to protect the lender to some degree if you were to default on your home loan.
At the end of the day, a lower DTI will improve your chances of getting approved for a mortgage at a lower interest rate. In contrast, a higher DTI will have the opposite effect.
Your DTI Doesn’t Paint the Full Picture of Your Ability to Afford a Mortgage
As helpful as DTIs are for lenders to determine your ability to secure a mortgage, they don’t exactly tell you everything when it comes to figuring out whether or not a mortgage is actually affordable for you. Even if you’re able to get approved, you might still find it difficult to comfortably afford that extra payment.
Your lender might take in a number of important factors into consideration to make sure you can cover this extra payment. But they don’t know all of the ins and outs of your life and other expenses.
For instance, groceries, child care fees, gas for your car, utilities, and other expenses are not required to be communicated to your lender. They won’t be factored into your DTI equation: only you can budget for these expenses, which is crucial.
The Bottom Line
A lower DTI is ultimately your goal when it comes time to apply for a mortgage. Aside from making more money, you can lower your ratio by paying down your debt. If you’ve got some time to play around with before applying for a mortgage, consider making a valiant effort to whittle down your debt. Consider focusing on higher-interest debt first, such as credit cards.
Doing so can not only help to lower your DTI, but it can also improve your credit score too, which are both important in securing a mortgage at a lower rate.