It wasn’t that long ago that the LA Times wrote a scathing article about the widespread effect that student loan debt is having on the housing market. One report they cited estimated that 414,000 home sales, or eight percent of the average number of annual home sales, would disappear because of this excess debt. The Federal Reserve Bank of New York backed this study up, claiming that people with student loan debt are less likely to hold a mortgage. Even the National Association of Realtors was quick to blame the sluggish housing market on student loan debt!
This was appalling news, indeed, especially considering the housing market has just barely started to recover and gain a little ground. With so many potential buyers out of the pool, further recovery would be slow, at best. But, maybe student loans aren’t going to ruin your chances entirely — just like other loans won’t dash your hopes of securing a mortgage. They’re all just pieces of a bigger number known as the debt to income ratio (DTI), a figure that banks use to determine your ability to repay a mortgage loan.
What is Debt to Income, Really?
Before we get too deep into this, I want to make sure you really, truly understand what the debt to income ratio is. This number isn’t arbitrary, it’s actually there for your benefit, believe it or not. For the purposes of borrowing money, your debt to income ratio basically caps how much you can borrow so you don’t get in over your head. When you’re a first time homebuyer, this is a great boon because you will probably underestimate what it really costs to own a home.
As the name implies, in this calculation your gross income is compared to your total debts. Easy, right? Where it gets tricky for a lot of people is what, exactly, your debts are. If you signed a note for a loan at a bank, make regular monthly payments on a note that’s got collateral, like a car or a boat, or have a credit card with a balance, these are definitely debts. If you are paying on a loan that you co-signed for someone else because they’ve defaulted, that’s your debt, too.
Even though you pay them every month and may even have a contract, cable, utilities and other subscriptions aren’t usually considered debt for mortgage purposes.
Examples of Debts Included in and Excluded from Debt to Income Calculations
|Included in Debt to Income Calculations||Not Included in D:I Calculations|
|Automobile Loans||Utility Bills|
|Personal Loans||Cable Contracts|
|Credit Cards||Rent-to-Own Furniture|
|Store Credit Accounts||Subscriptions (any kind)|
|Loans You’ve Co-Signed||Cell Phone Contracts|
|Student Loans (Calculated)||Recurring Medical Expenses|
When they do the calculation, your lender adds up all your current monthly debts and compares them to your current monthly gross income. So, if your car payment is $250, your student loan calculation is $300 and you’ve got a credit card with a $150 payment, but you gross $3300 each month, your current debt to income ratio is about 21 percent. Since most banks will loan to a 43 percent debt to income ratio, you’ve got plenty of room to buy a home. In fact, you can have a total of $1419 in monthly payments, making your total house payment (including principal, interest, taxes and insurance) $719. In many markets, this is a pretty decent house, so you’re good to go!
How Much DTI is Allowed for My Program?
FRONT-END / BACK-END RATIO
Front-end is the DTI before your new mortgage or replacement mortgage is figured in, the back-end is your total DTI
Your actual DTI allowance will be determined by several factors, including the type of loan you’re getting, your credit score, your cash reserves and your down payment. If you have a higher DTI than would normally be allowed by your credit score, you can often overcome this with what bankers like to call compensating factors. Significant cash reserves, length of employment at the same place, or a large down payment, for example, are favorites of underwriters everywhere. They show that you’re stable and ready to take on the responsibility of owning a home, so they make a huge difference.
For an FHA loan, you can cap out your ratios at 40/50, but you’ll really have to show that you’re doing well. A minimal increase in house payment plus well documented and verified cash reserves are a good place to start. A ratio of 40/40 is probably more realistic for most FHA buyers, where just one of the two will be expected. Conventional loans are similar, maxing out at 45 percent debt to income total.
VA loans are a different breed, and may be a bit too complicated to explain here. Basically, they allow up to a ratio of 41 percent, but for veterans with residual income, that number can be adjusted based on the residential income tables in your area. So, if your income exceeds the minimum residential income for your area and household size by at least 20 percent, that 41 percent DTI kind of goes out the window. You’ll want to get a pre-qualification from your lender before you start shopping with one of these, if DTI is a question at all.
When Your DTI is Too High
Even when you’re responsible with your credit, sometimes your DTI is simply too high. This is where a lot of people give up and go home — but sometimes there are other options. Here are a few of the easier ones:
A non-occupying co-borrower. If you’re borrowing using an FHA loan, you’re in luck! A family member or good friend can co-sign your loan to help improve your ratios. This is a tricky proposition, to be sure, but if your parents are mostly debt-free, your cousin started Google or you’ve got a good friend who has awesome credit, it might be an excellent choice. If you default, your co-borrower is on the hook for your loan, though, so be thankful if you can find someone who will do you this giant favor.
Co-borrowing with a spouse with low DTI. Many times, borrowers don’t want to involve their spouse or live-in significant other in the buying process. I’m no relationship counselor, but if you don’t trust them with your mortgage, you probably shouldn’t be cohabiting. There are reasons to keep them off the loan, to be sure, but if they’ve got a much lower debt to income ratio than you, adding your partner to the equation may compensate for your debt problem.
Refinancing or paying down other debts. It’s important to carry some credit lines to keep your credit history up to date, but too much debt will make your DTI excessively high. But, if you’ve got lots of equity in your car or other property securing a loan, consider paying the note off or refinancing to get a smaller payment. In most cases, you’re still allowed to make the higher payment you were used to, but the new, lower payment requirement will reduce your debt to income ratio on paper.
Bringing a larger down payment. Usually, I advise people to not bring more than a 10 percent down payment, since it hardly makes a difference in your loan rate or terms and it’s really good to have some cash on hand for household mishaps. But, if you’ve got a chunk saved and a high debt to income ratio, it may be a good idea to throw everything you’ve got at your loan. Debt to income is sometimes overcome a dollar at a time, so every buck counts! If you’ve got a family member willing to gift you funds to help reduce your principal and therefore your mortgage payment, so much the better!
The Bottom Line: Excessive Debt Isn’t the End
Heavy debts may feel like a huge weight on your shoulders, but in most cases they won’t prevent you from buying a home if you’re willing to do some extra work to get them under control. There are plenty of tricks for taming an out of control DTI, but you’ve got to keep your eye on the prize as you consolidate, eliminate and refinance debts. If the overall picture decreases your DTI enough to get the house you’re after, then you’re right on track.