Can you guess the number one reason behind rejected mortgage applications? Most people think the culprit is a low credit score. The real answer? A high debt-to-income (DTI) ratio.
In fact, a high DTI is the most common reason for mortgage denials, accounting for approximately 1/3 of failed applications.
So what exactly is a debt-to-income ratio, and why does it matter? We’ll go over the basics and tell you how to lower your ratio to increase your chances of successfully applying for a mortgage.
Your debt-to-income ratio tells lenders how much of your gross monthly income goes toward debt payments. These can include credit card payments, student loans, car loans, or other types of debt.
The lower your debt-to-income ratio is, the better. Most lenders prefer a ratio of 36% or below. However, this number will vary according to the lender and other conditions.
It may sound complicated, but figuring out your debt-to-income ratio is a relatively simple process.
To calculate, divide your total monthly debt payments by your gross monthly income. Monthly debt includes all forms of debt, including the mortgage, credit card payments, child support, auto loans, student loans, personal loans, etc.
DTI = Total Monthly Debt Payments / Gross Monthly Income
The resulting number will be a decimal, so multiply it by 100 to get a percentage.
For example, if your monthly debt adds up to $2000, and your monthly income is $6000, your DTI will be 33%.
Your debt-to-income ratio gives lenders a good picture of your overall finances. Like it or not, it’s one of the most critical factors for the approval of mortgage applications.
If your ratio is low, it demonstrates a good balance between money coming in and money set aside for debt. But if your ratio is high, then lenders see you as a risk. After all, if most of your current budget is already going towards paying off debts, how will you add a mortgage on top?
Most lenders look for applicants with a debt-to-income ratio below 36%.
Market studies suggest that your chances may be slim if your ratio is above 60%. Applicants with a DTI this high are typically rejected 85% of the time. The good news is that the rejection rate drops quickly once you lower your DTI.
Lowering your DTI by just a few percentage points to get into the 50-60% range reduces your chances of a failed application to around 21%. And a DTI of below 50% drops the rejection rate to single digits.
If your DTI is high, don’t lose hope. You can lower your score to an acceptable range with some extra planning. Here’s how to start:
• Focus on boosting savings. This will help you pay for unexpected costs in the future and prevent you from taking on more debt.
• Lower your monthly debt payments. You can do this by paying off high-interest debt first, like your credit card. Then, focus on lower interest loans like personal and auto loans.
• Put off large purchases. This is not the time to add high-cost items to your credit card bill.
• Re-evaluate every month. Stay motivated by keeping track of your progress. As you see your ratio lowering, it will give you the energy to keep saving.