Low Debt To Income Ratio
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Having good credit scores is not the only factor in getting approved for a mortgage loan. One of the main criteria is having a low debt to income ratio.
There are 3 factors banks take into consideration when approving a home loan: 1) An individual’s credit score, 2) Their income and job history and 3) Their debt to income ratio.
In an extreme example, a teenager may have an 800 credit score but they can’t necessarily buy a home. While an individual’s credit score is important to a bank they also look at income debt ratios and job stability as important factors.
Debt ratio is simply defined as the ratio between what an individual earns and how much they pay monthly in installment and revolving debt. For example, if a couple makes $6000 monthly, but $3000 is required each month for rent, credit card payments and car payments, this couples debt to income is 50%. $6000/$3000= 50%.
Banks prefer to make home loans to individuals with low debt to income ratios because they feel the lower a person’s ratio, the easier it will be for them to make their mortgage payments on time.
How does revolving debt and installment debt factor into getting a mortgage loan?
An example of a revolving debt account is a credit card. There’s really no “end point” to the debt because it’s basically an open-ended line of credit. The debt can fluctuate from really low one month to really high the next. It revolves.
Conversely, installment debt has a predetermined time-line. Home loans, car payments, student loans fit this debt category. These debts can’t be increased monthly once the agreed upon terms have been set by the lender. These loan amounts simple decrease monthly, on an installment basis.
When a bank is calculating your debt ratio they usually won’t let you pay down revolving debt as a qualifying factor. The reason being that you can simply re-charge the revolving account back to a high amount quickly after the new loan is issued.
However, banks usually allow the pay off of installment debt since these debts can’t be re-charged. Once they’re paid off they no longer exist.
Student loans can negatively impact one’s debt to income ratio. Often individuals falsely believe that if they have high credit scores they should easily qualify for a home loan. Student loans can be a problem even if you are not actively paying on the loan. Actually, a student loan that is deferred can give you a worse ratio.
This occurs because deferred student loans trigger the mortgage bank to require the mortgage broker to count this as an existing debt. The banks are required to charge in the range of 3%-5% of the outstanding loan towards the borrower’s debt ratio.
For example, if a student has a $30,000 loan that is deferred, the loan officer must qualify this borrower with a $900-$1500 student monthly loan! This can be a significant problem when securing a no-PMI loan, an 80/10 (90% mortgage) or an 80/15 (95% mortgage) home mortgage loan.
Whenever a “no PMI” loan is sought, debt ratio is a major issue because second lien companies are usually stricter than the first lien mortgage company. Second lien companies generally prefer debt to income ratio in the 40-45% range. So if one’s debt ratio exceeds 45% they will probably have to get a single, first lien, which will include PMI.
As you can now see, getting approved for a mortgage loan requires more than just having good credit scores. In addition to good credit scores, the next major is criteria are having a low debt to income ratio.
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