Let’s say you’re buying a house and you have calculated your front ratio or the comparison of your proposed housing debt to your usable income. You know your lender allows a 43% total DTI ratio, and your front ratio is an enviable 36%. But your loan officer informs you that your total or “back” DTI is 53%! Your loan is on a credit officer’s desk for final review but it might be declined.
What do you do?
In order to fight this underwriting decision and get back on track to your loan being approved, you need to understand what goes into the total debt calculation.
Underwriters calculate the total DTI ratio by adding your proposed (or estimated) housing debt (principal, interest, taxes and insurance) to your “other” debt, such as payments on car loans, car leases, credit card debt, or student loans.
If you had no such other debt, your front ratio would have been identical to your back ratio (36/36), but you must have debt because your back ratio is significantly higher than your front ratio. You ask your loan officer to list the monthly debts that the underwriter is using.
The first item is a car lease for $300 a month. The next is child support payments to your ex-wife for $550 a month. The last item is a mortgage payment on a condo in Florida. You are surprised that they’re counting all this debt against you. You go through them one by one.
- The car lease is your sister’s — you just co-signed for her because she couldn’t qualify on her own.
- The child support payments are almost over. Your kid will be eighteen in six months and at that point, the payments cease.
- The condo is an investment property that you get rental income from. It more than pays for itself.
Your loan officer goes back to the underwriter and relays your answers. The underwriter says this is all good news because if you can supply adequate documentation, she might be able to remove all three items from your DTI calculation!
What kind of documentation is needed to remove debt from your DTI?
- For the first item (the cosigned car lease), you need to provide twelve month’s canceled checks from your sister showing she pays the car lease every month. Otherwise, a cosigned debt is treated as if it’s your debt, and you have to qualify carrying that debt.
- For the child support, if it has less than ten months left to go, they don’t need to count it against you. You say you can provide the divorce decree and your child’s birth certificate. Those two pieces of information clearly show that child support will end when the child is eighteen, and the birth certificate shows they will be eighteen in a few months.
- For the condo, you need to show the rental agreement and your Schedule E on your tax returns showing that you declare the rental income so you can use it to offset the debt.
What if you hadn’t been able to reduce your debt so easily? What else could you have done to reduce your overall DTI ratios?
Some people would tell you to take an ARM instead of a fixed. It stands to reason that if the rate on the loan is lower, it will be easier to qualify. But this is not always the case. Many ARMs make you qualify at the higher of the fully indexed rate or the note rate.
A year ago (on Jun 20, 2019), if you found a 5/1 ARM in the 3.5% range, you would still have to qualify using 1 Year LIBOR plus a margin. 1 Year LIBOR was at 2.26%, and the standard margin was 2.25%, so your fully indexed rate would have been 4.51%, which was much higher than a 30-year fixed rate (3.84%) at that time.
Some longer term ARMs (like a 7/1 or 10/1) let you use note rate to qualify, but ARMs are not always an easy qualifier.
Another way to reduce your DTI would be pay off debt. Remember the child support that you were able to eliminate because it had only a few months left to go? That is a widely accepted underwriting approach to omitting debt. If the debt has ten months or less left to go, you don’t have to count it. This works for car loans, student loans, personal loans — everything but car leases (because unlike with a loan, when a lease is over, you have to turn in the car and presumably get a new lease). So if you have other debt that’s dragging down your ratios, you can make it “disappear” by paying it down to ten months or less.
What’s another way to eliminate debt?
By showing someone else pays it, like with the example of your sister’s car lease. You were able to show that she actually pays it, not you. What if you had a car lease in your own name only, but your business paid it? Then you would use the same tactic to make it go away: show 12 month’s canceled checks from your business. Once you do that, your underwriter can omit it from your ratios.
The last way to reduce your DTI is to tackle it from the income standpoint: add a cosignor. The cosignor would add their income to your ratios to help you qualify. However, the cosignor’s debt gets added too, so if they have some income but a lot of their own debt, they will not help you qualify. Your ideal cosignor is someone with a lot of income and minimal debt. But they should be aware that cosigning a loan means they are on the hook if you don’t pay. It’s just like they’re applying for their own loan.
After using all these different methods, if you still can’t lower your DTI, your options are to ask your loan officer if he has any other programs that allow higher DTI or that would make an exception. If everything else in your file is strong, that may be an option.