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Starting to Shop for a Mortgage? How to Assess Your ‘Debt-to-Income Ratio’ and Why This Number Matters

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Starting to Shop for a Mortgage? How to Assess Your 'Debt-to-Income Ratio' and Why This Number MattersThose who are looking to buy a home may want to start by shopping for a loan first. Having financing ahead of time may make it easier to get sellers to take a buyer seriously and help move along the closing process. For those who are looking to get a mortgage, the most important factor for having a mortgage application approved is the debt-to-income ratio of the borrower.

What Is a Debt-to-Income Ratio?

A debt-to-income ratio is simply the percentage of debt compared to the amount of income that a person brings in. If a person brought home $1,000 a month and had $500 worth of debt, that person would have a DTI of 50 percent. To improve the odds of getting a home loan, experts recommend that potential borrowers keep their DTI under 43 percent.

What Debt Will Lenders Look At?

The good news for borrowers is that lenders will disregard some debt when calculating a borrower’s DTI. For example, a health insurance premium would not be considered as part of your DTI while, and income is calculated on a pre-tax basis. This means that a borrower doesn’t have to factor in taxes when calculating their qualifying income.

What lenders will look at are any installment loan obligations such as auto loans or student loans as well as any revolving debt payments such as credit cards or a home equity line of credit. In some cases, a lender will disregard an installment loan debt if the loan is projected to be paid off in the next 10-12 months.

What Is Considered as Income?

Almost any source of income that can be verified will be counted as income on a mortgage application. Those who receive alimony, investment income or money from a pension or social security will have that money included in their monthly income when they apply for a loan. Wage income is also considered as part of a borrower’s monthly qualifying income. Self-employed individuals can use their net profit as income when applying for a mortgage. However, many lenders will average income in the current year with income from previous years.

How Much Debt Is Too Much Debt?

Many lenders will only offer loans to those who have a debt-to-income ratio of 43 percent. However, government backed loans may allow borrowers who have a DTI of 50-55 to qualify for a loan depending on their income and other factors. Talking to a lender prior to starting the mortgage application process may be able to help a borrower determine if his or her chosen lender offers such leeway.

A borrower’s DTI ratio may be the biggest factor when a lender decides whether to approve a mortgage application. Those who wish to increase their odds of loan approval may decide to lower their DTI by increasing their income or lowering their debt. This may make it easier for the lender and the underwriter to justify making a loan to the borrower.

How Do Mortgage Lenders Decide How Much You Can Borrow?

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How Do Mortgage Lenders Decide How Much You Can Borrow?When you visit your lender to get a mortgage for your home, they will tell you the maximum amount that you are allowed to borrow. But how do they reach this total and what factors do they take into consideration?

How do they determine that one borrower can take on a bigger mortgage than the next? This decision is made by mortgage companies by considering a wide range of factors, including your credit information, your salary and much more.

Here Are Some Of The Common Ways That Lenders Determine How Much You Can Borrow:

1. Percentage Of Gross Monthly Income

Many lenders follow the rule that your monthly mortgage payment should never exceed 28% of your gross monthly income.

This will ensure that you are not stretched too far with your mortgage payments and you will be more likely to be able to pay them off. Remember, your gross monthly income is the total amount of money that you have been paid, before deductions from social security, taxes, savings plans, child support, etc.

2. Debt To Income Ratio

Another formula that mortgage lenders use is the “Debt to Income” ratio, which refers to the percentage of your gross monthly income that is taken up by debts. This takes into account any other debts, such as credit cards and loans. Many lenders say that the total of your debts shouldn’t exceed 36% of your gross monthly income.

The lender will look at all of the different types of debt you have and how well you have paid your bills over the years. By using one of these two formulas, your mortgage lender calculates the size of a mortgage that you can afford.

Of course, there are many other factors that need to be considered, such as the term length of the loan, the size of your down payment and the interest rate.

Remember that when factoring in your income, you usually have to have a stable job for at least two years in a row to be able to count your income. If you want to increase your chances, you could consider paying down your debts or buying with a co-borrower, which will improve your debt to income ratio.

For more info about mortgages and your home, contact your mortgage professional.

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