Understanding your debt-to-income ratio when purchasing a home is essential, especially now that interest rates have risen.
A debt-to-income ratio (DTI) measures how much of your monthly income goes toward debt payments. The Debt-to-Income (DTI) ratio is a revealing metric, indicating whether your debt aligns reasonably with your earnings. Striking a balance in debt obligations is vital to fostering stable financial health.
If you’ve ever explored mortgage options, you’re likely already acquainted with this computation. Your debt-to-income ratio plays a critical role in the assessment made by lenders to gauge your capacity for meeting monthly payments on the funds you intend to borrow.
Lenders employ the DTI as a yardstick to determine the sum they can prudently lend you for a home purchase or mortgage refinancing, all while mitigating their financial risks. Undoubtedly, your credit score’s significance in loan qualification is common knowledge. Yet, the DTI is equal to the credit score regarding its importance.
The 28/36 Rule is typically used by lenders to calculate the debt-to-income ratio.
28% of your gross monthly income is allowed by lenders for housing expenses, including principal, mortgage interest, real estate taxes, and insurance.
36% of your gross monthly income is what the lender will allow for your total monthly debt payments. This number will include housing expenses, credit card payments, child support, car loans, and other long-term debts.
Calculating the debt-to-income ratio is simple:
Monthly gross earnings $6,000
28% $1,680 maximum monthly mortgage payment*
*Your maximum monthly mortgage payment includes principal, interest, taxes, and insurance (PITI). Lenders will typically limit this amount to a conventional monthly mortgage payment, translating to the amount of home you can afford.
Monthly gross earnings $6,000
36% $2,160 total allowable monthly debt*
*This figure represents your total of all allowable debt.
Total allowable monthly debt $2,160
Less maximum monthly mortgage payment $1,680
Allowable additional recurring monthly debt $ 480
If your monthly obligations on recurring debt exceed $480, the size of the mortgage you’ll qualify for will decrease proportionally. For example, if you pay $600 monthly on recurring debt instead of $480, the lender must reduce your monthly mortgage payment by $120 to $1,560 or less. The difference means a lower mortgage amount and a smaller home.
It is important to note that car payments are a part of that $480 allowable recurring monthly debt. With the increase in vehicle costs, having a $500+ monthly car payment is common, even for a modest vehicle. There is little room for any additional debt.
Each lender evaluates the debt-to-income ratio based on the guidelines they set. Some lenders may allow percentages over 36%, depending on their set parameters.
Simply put, too much debt can derail your mortgage approval.
You can reduce your debt-to-income ratio by:
- Paying down your debt.
- Increasing your income.
- Avoiding additional debt.
It’s a good idea to keep an eye on your debt-to-income ratio whether or not you’re in the market for a home. Access to other lines of credit makes it easy to get over your head.
A home purchase is an exciting time in one’s life. Understanding the home-buying process is crucial whether you are a first-time homebuyer or an experienced one.
Over my 20 years of experience in the local Pittsburgh real estate market, I have helped many home buyers achieve their dream of homeownership. Contact me here, by phone at 412-848-3907, or by email at Kim.Esposito1@pittsburghmoves.com to schedule a free consultation to discuss your real estate needs.