Your debt-to-income ratio will help answer that question. This metric measures the percentage of your monthly income that should go toward your mortgage backing your first home purchase that is affordable for you. Mortgage reforms encapsulated by the Dodd-Frank Act aim to help you and other consumers be aware of the limits on how much of your income should go to your debt by requiring lenders to look at your DTI based on set standards.
The Debt to Income Ratio
Lenders use the debt-to-income ratio to determine if (a) you are able to take on another debt given your current income and (i) you are able to repay this debt in the future.
There are two ways to calculate this DTI ratio. There is the front-end, which takes into account your total housing costs divided by your gross monthly income. Then there’s the back-end or total ratio which is all debt obligations including housing costs relative to your gross monthly income.
In the case of mortgages, lenders will focus more on the front-end ratio. In calculating this ratio, they will include future payments on the mortgage you’ll be taking on.
The Ideal DTI: Your Mortgage vs Your Income
Under the Dodd-Frank Act, lenders are required to assess the borrower’s ability to repay his/her mortgage based on credit scores, DTI and so on. If lenders are doing their part, they should be able to make a qualified mortgage which is free of harmful and risky features.
A QM, for example, has a total DTI ratio including the mortgage payments of 43% at the very most. Even with this 43% threshold, lenders generally require a more stringent DTI ratio of 28%. This means that no more than 28% of your monthly income should go to your mortgage payment every month.
Say you’re making $4,648 every month. Twenty-eight percent of this amount is $1,301 ($4,648 multiplied by 0.28). This is your ideal mortgage payment, anything greater than this could be burdensome unless you are expecting a pay raise, promotion, or a windfall perhaps later on.
To You, How Much Can You Really Afford?
From a lender’s point of view, the debt-to-income ratio tells your ability to manage your debt. The lower this ratio, the “more able” you are in managing your debt. If your DTI is too high, you are likely at risk of not being able to pay off your debts.
What you can do is to free up your debts before submitting your mortgage application and avoid taking on a new one, unless necessary.
From your end, you can use the 28% benchmark to determine the mortgage debt you can comfortably take on. In calculating your projected mortgage payment, take note of its main components: loan principal, loan interest, property taxes and homeowner’s insurance.
If you plan to put less than 20% of the home’s purchase price, include the costs of a mortgage insurance as well. You can obtain quotes from multiple lenders, insurers, and local taxing authorities to help you come up with a more realistic calculation.
In the event your debt ratio exceeds lender standards because of student loans perhaps, you can still find a mortgage. FHA loans allow for a front-end ratio of 31% and non-qualified mortgages like stated income loans have a more relaxed stance toward DTI scores.
The key is to use certain factors to downplay your high DTI and make up for it. These compensating factors include putting a higher down payment, maintaining an excellent credit score, or setting aside funds worth more than six months of mortgage payments.
Justin McHood is a managing partner at Suited Connector and has been recognized by national media outlets as a financial expert for more than a decade.
