Before applying for a loan, the home buyer needs to do some homework!
There is probably no bigger deal killer in housing finance (outside of a low FICO score) than the dreaded debt-to-income ratio. Dreams have been taken away, and plans have been ruined over debt-to-income ratios that were just too high for a lender’s tolerance. For whatever reason, most people are not aware of this dream slayer. This is fascinating because its calculation is relatively straight forward. However, the number of individuals who take the time to calculate this ratio is very small. This calculation would save a lot of frustration and tears. If borrowers know how to figure out the DTI, they’ll know what to do to qualify for the purchase of their dreams. And the best of it, it is only very basic math.
What to do first
A prospective purchaser should get a copy of their recent credit reports. Ideally he should get them from all three credit agencies (Equifax, Experian, and Transunion). Verification of their gross income (e.g. pay stubs, two years tax returns, or W2s) is the next step. The “D” in DTI stands for debt. Prospective borrowers should review their financial obligations by using their credit reports. They need to determine what their required minimum monthly debt payments are. Once they figured that out, they add the principal, interest, taxes, insurance and monthly HOA expenses (if any) of their target property.
A Second Step
Under most circumstances, the minimum payment is what banks use for credit cards (except American Express). Monthly student loan payments, if any, need to be included (unless the student loan has a bona fide deferral of two years or more) to determine monthly debts.
The second step is to identify the “I” for income. The calculation is straightforward. Divide the yearly income by 52 weeks and then multiplied again to determine the monthly income. Add bonuses only if there is a two-year history of earning them. Non-reimbursed expenses are subtracted from the income if reported on a borrower’s tax returns on the IRS form-2106.
For the self-employed, it is a little more complicated. For them, it’s all about line #37- “adjusted gross income” (AGI). They usually have to show their last two tax returns. Very few lenders accept “stated income,” and if they do they charge astronomically high interest rates.
The Last Two Years are always Crucial
So, the last two years of a borrower’s AGI will determine the income for those who are self-employed. This is where an entrepreneur needs to be mindful of how many deductions they want to take or need to take. For self-employed this is a painful catch 22. If they deduct too much, their income may not be sufficient, and they won’t qualify. If they deduct too little, they will pay Uncle Sam a lot more in taxes than they should.
Now, the “D” and the “I” have been calculated. Take a paper and pen or a calculator and divide the debt by the income. Although Fannie Mae’s and Freddie Mac’s automated systems have been known to “approve” transactions with debt to income ratios as high as 52%, the published maximum is probably more around 45%. The maximum for FHA transactions is 57%. With this information, a borrower can calculate their present DTI and determine which components to decrease to reduce the ratio if necessary.
What can You do to get a Better Credit
For the most part, income “is a given.” There isn’t much one can do. Asking for a pay rise may be one option; however, it may not work out like expected. The only other consideration to increase the “I” for income is probably to bring in a co-borrower or co-signer. The parents of a first time home buyer may be happy to do that. Or maybe not?
Sometimes it is easier to address the debt problem instead. If borrowers have reserves or other means available to them, they can pay off their credit cards. Car loans can be removed from the ratio if the remaining loan balance equals ten car payments or less, and the lender may find a way how to deal with a student loan.
The only problem is that not everybody has so much cash on hand, especially since the buyer needs money for the down payment, too.
The is one thing a borrower can do, which requires at little “bravery” on his side. This is to curb their enthusiasm and go for a lower priced property. The outcome may not be the exact dream home anymore, but this solution is in any circumstances better than a permanent nightmare.
Knowing one’s DTI and knowing how to manipulate it are key to getting an approval. Pull out your calculator and your credit report and crunch those numbers. You will be glad that you did – and do it before you see the loan officer.
Important: Difference between Approved and Pre-Qualified – it is not the same!
Get approved – not pre- qualified. What is the difference? Pre- qualified sounds pretty official, but it is only an idea of what you can afford. One can also say that a pre-qualification is based on assumptions and good will. The buyer tells the lender about his income and his debt obligations. The lender does not even check the details! Based on this vague information the loan officer or mortgage broker writes a letter stating that he may be willing to lend if everything turns out to be correct and by the guidelines.
This piece of paper has very little value when purchasing a home. Only when a lender has actually reviewed the credit history, has verified the assets, has calculated the DTI, and has checked the employment history, the buyer will get a real document – which can be called a firm approval.
Of course, sellers like to see a firm approval, not a vague pre-qualification. If you are competing with another buyer who has only a pre- qualification but you hold a firm approval in your hands, you will be in the better position.