Why Experts Say 43 Is the Magic Number Potential Homeowners Should Know
If you’re getting serious about buying a home, you’re probably paying close attention to your credit score. After all, an excellent credit score—one that’s 740 or above—will get you the best possible rate on a mortgage. Even so you could still qualify for a Federal Housing Administration, or FHA, loan with a score in the 500s.
But there’s another figure—your debt-to-income ratio, or DTI—that lenders are looking at closely. In fact, like your credit score, your DTI determines whether or not you can qualify for a mortgage at all. Interestingly, it’s n˜ot a number that prospective buyers can usually rattle off like they can credit scores.
Here’s what you need to know about DTI, including the ideal ratio lenders want to see, how it’s calculated, and how you can improve your debt-to-income ratio.
What’s a good DTI ratio?
When it comes to DTI, the magic number is typically 43, explains Casey Fleming, a mortgage advisor and the author of The Loan Guide: How to Get the Best Possible Mortgage. Your total monthly obligations should not exceed 43 percent of your gross income, which is your income before payroll deductions, he says.
In the past, buyers who purchased homes through government-sponsored loan programs like Fannie Mae and Freddie Mac were allowed to have a 50 percent DTI. But in January 2013, the Federal Housing Finance Agency reduced those agencies’ DTI allowance to 43 percent or less. Buyers with FHA loans, though, can still have a debt-to-income ratio of up to 50 percent, Fleming explains.
In 2018, more than half of denied mortgage applications had DTI ratios exceeding 43 percent, according to Home Mortgage Disclosure Act data released by financial analytics company CoreLogic.
What factors into DTI?
Wondering how your debt-to-income ratio is calculated? The simple answer: Divide your total monthly obligations by your total gross (i.e. pre-tax) monthly income, explains mortgage lending compliance expert Anna DeSimone.
Total obligations are comprised of the estimated proposed housing payment—which would include property taxes, hazard insurance, and any condo dues—plus the monthly payment of any student loans, auto, or installment loans that have 10 or more remaining payments, explains DeSimone, the author of Housing Finance 2020. Monthly expenses also include 5 percent of the combined balances of revolving credit cards, she says.
In theory, all ongoing debt obligations should be included when you’re debt-to-income ratio is being calculated, Fleming explains.
“For underwriting purposes, though, the lender only sees what is reported on the credit report, so personal loans that are not reported to the credit bureaus should be included, but often are not,” Fleming says.
As for income, if you’ve got a side hustle on top of your regular job, underwriters will want to see at least two years of net income on a borrower’s tax returns, showing that the income is verifiable, sustainable and likely to continue, Fleming explains. The last two years of income is averaged, unless the income looks to be decreasing, in which case, underwriters will look at the most recent year.
How can you better your DTI before buying a home?
If you’re looking to improve your debt-to-income ratio, you can take a strategic approach to paying down your debts, experts say.
“Paying off credit cards seems like a good idea, but it’s best to take this step 6 to 12 months before you start house hunting,” DeSimone says. “Sometimes credit rules are based on the past 12 months’ average credit use.”
Also, the “5 percent rule” for credit card usage that’s factored into DTI is actually favorable, since it’s often less than the minimum payments required by creditors, DeSimone says.
When it comes to your car payments, take a look at how many you have remaining. DeSimone provides this scenario:
If you have a $300 monthly car loan and 15 payments remaining (from the date of your loan application), you can “pay down” your balance to 10 payments if you have $1,500 in spare cash. Then, bring the proof to your mortgage lender that you paid the five payments, and the $300 monthly payment will be removed from your DTI, she says.
The thing to remember when it comes to DTI? Shopping for a mortgage and only caring about your credit score is kind of like going to the gym and just doing cardio, while ignoring the weight machines. A good debt-to-income ratio will give you the financial muscle, so to speak, that you need to secure a mortgage.