How Mortgage Lenders Calculate Your Debt Ratio to Determine What Price House You Can Afford

kitchen counter top viewBefore you fall in love with that gorgeous home, figure out whether or not you can afford it. Remember this:

The one who holds the money makes the rules.

If the underwriter says your debt ratio is too high, you will be denied. (And be forewarned: the spreadsheet you made showing you can afford it means nothing. The underwriter will not give it a moment’s glance.)

As I mentioned in a previous post, your loan officer can calculate your debt-to-income (DTI) ratio for you. But what if you want to do it yourself? What if you want to double-check the loan officer? Here’s how it’s done.

1) Take your gross income (before taxes and other deductions). Use the highest figure on your W-2 forms. You must have been employed in the same line of work for the last two years in order to count the income. If you have a brand new part-time gig, it won’t count. If you have brand new bonus income, it won’t count.

For self-employed people, use the Adjusted Gross Income near the bottom of page one of your tax returns. Again, you must be self-employed for the last two years. If you have a new business, you cannot count your self-employment, even if it is in the same line of work as your previous W-2 job.

2) Add up your monthly outgo. Use all of the minimum payment obligations that show on your credit report. If you pay your entire credit card bill each month, you do not use that balance in your outgo; instead, use only the minimum payment required.

Do not count expenses that do not show on a credit report such as phone, utilities, cable, gas or bus, or grocery.

Add in the new proposed mortgage payment for the house you want to buy. Include principal, interest, taxes, insurance, and monthly mortgage insurance if putting less than 20% down. (You can use the easy calculator at MortgageHelper.com here.)

3) Divide your total outgo by your gross income. This is your DTI. Most mortgage lenders want to see a max of 38% DTI, but some will go higher if the rest of your application is strong. The highest I’ve seen is 49% DTI with a 800 credit score and significant cash reserves.

For example, if your gross income is $5,000/mo. and your outgo is $3,000/month:

5,000 divided by 3,000 = 60 DTI. That is too high and will be denied.

You would then need to pay down debts and/or choose a less pricey house.

By knowing your price range, you avoid the disappointment of being denied. And again, if it seems too complicated to calculate yourself, all loan officers at mortgage companies and banks are happy to do it for you. They love using their handy HP calculators, so don’t hesitate to ask.

Happy house hunting! It’s a good time to own your own home.

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