This equation, comparing how much money you owe to the money you make, affects whether you can qualify for a mortgage but let’s unpack this important term into plain old dollars and sense.
Debt is the money you owe to another party. As a consumer, your debt load is what you owe in obligations like credit card payments, student loans, car loans, installment loans, personal debts, alimony, or child support. Meanwhile, income is the sum of the money you make from your job, part-time work, alimony, or income-producing assets such as real estate or stocks. So what do debt and income have to do with obtaining a home loan?
What is debt-to-income ratio?
Your debt-to-into (DTI) ratio helps lenders figure out how (or whether) a home purchasing can fit into your financial picture. To calculate your DTI ratio, you simply divide your ongoing monthly debt payments by your monthly income.
For revolving debt like a credit card, use the minimum monthly payment for this calculation. This might not match what you typically pay each month. Hopefully, you’re paying off your credit cards as quickly as possible, in order to reduce how much money you pay in interest. However, the minimum payment is what most lenders use when calculating DTI.
For installment debt, which is money you owe in fixed payments for a fixed number of months use the current monthly payment.
Why does it matter?
Lenders use your DTI ratio to assess your ability to pay for a loan. Lenders like this number to below. This is because evidence from studies of mortgage loans shows that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments.
As a general rule, if you qualify for a mortgage, your DTI ratio cannot exceed 36% of your gross monthly income. A higher DTI ratio could mean you’ll pay more interest, or you could be denied a loan altogether.
Some lenders will loan money to people with DTI ratios exceeding 36%, but it’s rare. After all, if you default on your mortgage and your lender has to foreclose on your home, your lenders may not be able to recoup their full investment. Plus a foreclosure can destroy your credit score, which would make it even harder to qualify for another mortgage.
To verify income, a mortgage lender will want to see recent pay stubs and W-2 tax forms for the past two years. If you’ve recently had a change in pay, such as a raise, you’ll need to get a statement from your boss confirming your new salary. If you generate income from a source outside your primary job you will have to provide W-2 forms for these as well.
