| Your debt-to-income ratio (DTI) is a simple way of | | | | your level of income. That's why the DTI is treated |
| calculating how much of your monthly income goes | | | | separately as a critical filter on loan applications. So |
| toward debt payments. Lenders use the DTI to | | | | even if you have a PERFECT payment history, but |
| determine how much money they can safely loan | | | | the mortgage you've applied for would cause you to |
| you toward a home purchase or mortgage | | | | exceed the 36% limit, you'll still be turned down for |
| refinancing. Everyone knows that their credit score is | | | | the loan. |
| an important factor in qualifying for a loan. But in | | | | The 28/36 rule for debt-to-income ratio is a |
| reality, the DTI is every bit as important as the | | | | benchmark that has worked well in the mortgage |
| credit score. | | | | industry for years. Unfortunately, with the recent |
| Lenders usually apply a standard called the "28/36 | | | | boom in real estate prices, lenders have been forced |
| rule" to your debt-to-income ratio to determine | | | | to get more "creative" in their lending practices. |
| whether you're loan-worthy. The first number, 28, is | | | | Whenever you hear the term "creative" in connection |
| the maximum percentage of your gross monthly | | | | with loans or financing, just substitute "riskier" and |
| income that the lender will allow for housing | | | | you'll have the true picture. Naturally, the extra risk is |
| expenses. The total includes payments on the | | | | shifted to the consumer, not the lender. |
| mortgage loan, mortgage insurance, fire insurance, | | | | Mortgages used to be pretty simple to understand: |
| property taxes, and homeowner's association dues. | | | | You paid a fixed rate of interest for 30 years, or |
| This is usually called PITI, which stands for principal, | | | | maybe 15 years. Today, mortgages come in a |
| interest, taxes, and insurance. | | | | variety of flavors, such as adjustable-rate, 40-year, |
| The second number, 36, refers to the maximum | | | | interest-only, option-adjustable, or piggyback |
| percentage of your gross monthly income the lender | | | | mortgages, each of which may be structured in a |
| will allow for housing expenses PLUS recurring debt. | | | | number of ways. |
| When they calculate your recurring debt, they will | | | | The whole idea behind all these newer types of |
| include credit card payments, child support, car loans, | | | | mortgages is to shoehorn people into qualifying for |
| and other obligations that are not short-term. | | | | loans based on their debt-to-income ratio. "It's all |
| Let's say your gross earnings are $4,000 per month. | | | | about the payment," seems to be the prevailing view |
| $4,000 times 28% equals $1,120. So that is the | | | | in the mortgage industry. That's fine if your payment |
| maximum PITI, or housing expense, that a typical | | | | is fixed for 30 years. But what happens to your |
| lender will allow for a conventional mortgage loan. In | | | | adjustable rate mortgage if interest rates rise? Your |
| other words, the 28 figure determines how much | | | | monthly payment will go up, and you might quickly |
| house you can afford. | | | | exceed the safety limit of the old 28/36 rule. |
| Now, $4,000 times 36% is $1,440. This figure | | | | These newer mortgage products are fine as long as |
| represents the TOTAL debt load that the lender will | | | | interest rates don't climb too far or too fast, and also |
| permit. $1,440 minus $1,120 is $320. So if your | | | | as long as real estate prices continue to appreciate at |
| monthly obligations on recurring debt exceed $320, | | | | a healthy pace. But make sure you understand the |
| the size of the mortgage you'll qualify for will | | | | worst-case scenario before taking on one of these |
| decrease proportionally. If you are paying $600 per | | | | complicated loans. The 28/36 rule for debt-to-income |
| month on recurring debt, for example, instead of | | | | has been around so long simply because it works to |
| $320, your PITI must be reduced to $840 or less. | | | | keep people out of risky loans. |
| That translates to a much smaller loan and a lot less | | | | So make sure you understand exactly how far or |
| house. | | | | how fast your loan payment can increase before |
| Bear in mind that your car payment has to come out | | | | accepting one of these newer types of mortgages. |
| of that difference between 28% and 36%, so in our | | | | If your DTI disqualifies you for a conventional |
| example, the car payment must be included in the | | | | 30-year fixed rate mortgage, then you should think |
| $320. It doesn't take much these days to reach a | | | | twice before squeezing yourself into an adjustable |
| $300/month car payment, even for a modest | | | | rate mortgage just to keep the payment |
| vehicle, so that doesn't leave a whole lot of room for | | | | manageable. |
| other types of debt. | | | | Instead, think in terms of increasing your initial down |
| The moral of the story here is that too much debt | | | | payment on the property in order to lower the |
| can ruin your chances to qualify for a home | | | | amount you'll need to finance. It may take you longer |
| mortgage. Remember, the debt-to-income ratio is | | | | to get into your dream home by using this more |
| something that lenders look at separately from your | | | | conservative approach, but that's certainly better |
| credit history. That's because your credit score only | | | | than losing that dream home to foreclosure because |
| reflects your payment history. It's a measurement of | | | | increasing monthly payments have driven your |
| how responsibly you've managed your use of credit. | | | | debt-to-income ratio sky-high. |
| But your credit score does not take into account | | | | |