How Lenders Evaluate Your Debt-to-Income Ratio
The debt-to-income (DTI) ratio is not the only number that lenders use to decide on a candidate, but it is an important tool that can augment the buyer's credit score. Unfortunately, even those with impeccable credit may still miss out on their dream home if their debt levels are too high. Find out more about how to calculate the ratio and what it takes to make it a little more palatable to lenders.
The Golden Ratio
DTI is calculated by debts to income. These debts include the following:
- Credit card debt
- Car loans
- Student loans
- Mortgage payments
- Official home fees (e.g., condo, HOA, etc.)
- Child support
As buyers can see, the DTI doesn't include insurance payments, utility costs, or other incidental expenses. However, it's important for owners to take into account how much they spend every month and compare it to their total income. Only then can buyers start to see if it's financially viable to buy the home.
What's the Ideal Number?
The goal is to get the buyer's DTI to 43% or lower. The lender wants to know that even if the borrower loses a significant source of their income (e.g., their job, etc.), they'll have enough to cover their mortgage until they can find another.
In addition to general household expenses, buyers should also take into account their taxes. Buyers making $5,000 a month are likely giving 20% to the government. That may only leave them with a few-hundred dollars by the time they finish paying off everything from groceries to their mortgage. To really dig into a personal DTI, it pays to consider how much is spent on entertainment, whether the car is likely to break down soon, and even where owners would prefer to retire.
The State of Canadian Home Buying
As buyers have likely already guessed, many homeowners have a higher DTI. This is a dramatic trend that has risen sharply in just the last decade, leaving the average household with a ratio of 171.1%. Lenders are responding to this trend by requiring more than just Lenders Mortgage Insurance (LMI) for their candidates; they're also charging higher interest rates. Buyers have to look at their amortization formula very carefully before deciding if they can accept the higher rates over the course of a 30-year loan.
It's recommended for buyers to approach both large and small creditors and to maybe even consult with a broker. Brokers handle countless products, many of which would be entirely inaccessible to buyers who don't have the time to research it all. This can result in better options, which can make it possible to get lower rates even with a shaky DTI.
And if it's at all possible, buyers are also encouraged to pay off as many debts as they can and to avoid new debt as much as possible. This move can both lower DTI and raise the credit score. If buyers still have questions about what can be done to better their circumstances, talking to a real estate agent or financial planner can make all the difference.
Creditors often see the DTI as the deal breaker. If they're hesitant about a certain candidate for any reason, they'll use the DTI number to decide whether to move forward or not. Penbrooke Meadows home buyers shouldn't be discouraged if they're turned down for a few loans, but a string of denials may mean they need to revisit their DTI.