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Your credit score is the number one thing that lenders look at, right? Not according to a survey conducted for credit-scoring company FICO. Nearly 60 percent of credit-risk managers surveyed said that a borrower’s debt-to-income (DTI) ratio is the biggest factor that would make them hesitant to approve a mortgage. A low credit score actually comes in third on the list, behind applicants who have submitted multiple credit applications recently.

In simple terms, your debt-to-income ratio is the percentage of your monthly gross income that goes toward paying all of your debts and liabilities, which includes your mortgage, credit card debt, student loans and other housing expenses. Your DTI ratio is broken down into two parts: front-end ratio and back-end ratio. With a few calculations, you can calculate your own DTI ratio and take steps to improve it.

Your front-end ratio is the percentage of your gross monthly income that goes toward your monthly housing payment. To calculate your front-end DTI ratio, divide your monthly housing payment (principal, interest, insurance, taxes, etc.) by your pre-tax monthly income. As a general guideline, you’ll want your monthly housing payment to be less than 28 percent of your gross monthly income. If it’s higher, that may be a red flag if you’re applying for a mortgage, although there is some flexibility in some cases.

The second part—your back-end ratio—measures your gross monthly income against all of your recurring monthly debts and liabilities and is generally considered the more important component of your overall DTI ratio. To calculate your back-end ratio, divide your total monthly credit card debt, student or personal loans, housing expenses, etc. by your pre-tax monthly income. Under the new Qualified Mortgage rules passed by the Consumer Finance Protection Bureau in 2014, most mortgages require a back-end ratio of 43 percent or less, although some Fannie Mae and Freddie Mac loans do allow for a higher debt-to-income ratio if the applicant has strong credit. Generally, a back-end ratio of 36 percent or less is considered a good goal if you’re looking to get a new mortgage.

If your back-end ratio exceeds the targeted percentage, there are ways to fix it. The most direct way to improve your ratio is to start paying down your recurring debt, such as the monthly balances on your credit cards. Paying down debt is usually much easier and more feasible than taking the reverse route of increasing your monthly income.

If you’re considering buying a home or refinancing in the near future, you’ll need to start working on your DTI ratio as soon as possible.

Posted by Kemmer Daniel Matteson on April 8th, 2015 7:05 AM


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