Q: Marsha, my partner and I just started looking for our first home to purchase. Our Realtor said we had to get loan pre-approval before we could even begin to look. We have gone to several different lenders and they’ve all said the same thing: Our debt-to-income level is too high. What is this exactly and what can be done? We are ready to purchase!
A: Your Realtor is right to have you obtain a lender pre-approval before you seriously begin your search. How else will you actually know how much home you can afford to purchase? It is the debt-to-income ratio, along with your credit score or FICO, that will determine your purchasing power.
Lenders work with two debt-to-income (DTI) ratios: the front-end ratio and the back-end ratio. The front-end ratio will calculate how much of your gross income will be spent on your monthly housing expense. This includes the mortgage payment, taxes, insurance, homeowner association fees, etc. This total amount is called PITI, which stands for principal, interest, property taxes, and insurance. This number will be divided by your partner’s and your gross monthly income (before taxes and other deductions from your paycheck). Lenders generally want to see this number at 30 percent or below.
The back-end DTI ratio is the more important figure. The back-end ratio includes all the borrowers’ debts — housing expenses, PITI, credit card debt, alimony, car loans, student loans, and any other recorded loans. This total number will be divided by the borrowers’ gross monthly income. The lower this back-end DTI ratio, the better. Conventional loans that are purchased by Fannie Mae or Freddie Mac should not have a back-end DTI of more than 43 percent.
When your lenders say your back-end DTI ratio is too high, what they mean is that your DTI is too high to obtain the best interest rates available. The rates you hear about in the news are for A-plus borrowers. These people have high credit scores, fantastic DTI, are not self-employed, are never late on payments, and are purchasing or refinancing a single-family residence.
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If you don’t fit perfectly into this scenario, your interest rate will be higher. How much higher depends on your personal story. A lot can be done to improve your DTI. Dive into your credit report. What outstanding debts are keeping your DTI too high? Perhaps you can pay off your car loan or pay down your credit cards. There could be old debts that are paid off and the creditor didn’t remove the information. Don’t get discouraged if you are unable to get the interest rate you wanted.
You may choose to accept a higher interest rate for your first purchase, and that’s fine. Jump in and make your first property purchase. The odds are strong that this will not be your “forever home.” Once you’ve purchased your home, go to work diligently to lower your DTI and improve your credit scores. No one knows where interest rates will be in a year. You may be able to refinance your home and drop your payments. Don’t let your DTI and a higher interest rate stop you from making your first purchase.
Marsha Gray, DRE #012102130, NMLS#1982164, has been a real estate broker in Santa Barbara for more than 20 years. She works at Allyn & Associates, real estate services and lending. To read more Q&A articles, visit MarshaGraySBhomes.com. She will research and answer all questions submitted. Contact Marsha at (805) 252-7093 or MarshaGraySB@gmail.com.