How Much Debt Can You Have While Buying a Home?
Worried that your Mastercard bill and student loan payments are preventing you from buying a home? Maybe you can. If you are wondering what is the debt to income ratio for FHA home loans, you might be surprised to learn that the answer is: it depends.
Check your FHA loan eligibility (June 29, 2021)
The relationship between debt and income
When you borrow money to buy a home, your lender examines your credit score. Additionally, a lender compares your monthly debt payments with your gross monthly income to generate a debt-to-income ratio, or DTI.
Your DTI includes the minimum payment on each debt listed on your credit report, the other debts on your loan application, and the monthly payment on your new mortgage.
The maximum allowed DTI for a qualified mortgage loan is generally 43%. However, in some cases the loans purchased by Fannie Mae can be as high as 50%. The maximum DTI for FHA home loans ranges between 40 and 50 percent for FHA applicants.
FHA loans, insured by the federal government, generally offer more lenient qualifying guidelines. They are a good option for borrowers whose credit is not perfect or who want to limit their down payment to 3.5%.
Lenders assess three characteristics when they take out your loan application: DTI, your loan-to-value ratio or LTV, and your FICO (credit) score. The graph below shows the average characteristics of FHA approved buyers.
The factors balance out – if you want a loan with a lower than average FICO, you will likely have to be better than average with your down payment or DTI.
What’s included in your DTI
On the debt side, your lender includes your monthly payment of principal, interest, property taxes, HOA contributions (if applicable), home insurance, and mortgage insurance.
FHA loans require mortgage insurance. Your debts also include minimum payments on your credit card balances, student loans, installments, and other accounts. If your student loan payments cannot be documented, the FHA loan guidelines assume a monthly payment of one percent of the balance.
Installment loans that will be repaid within 10 months will not count towards your DTI. However, your lender must include the amount of this payment that exceeds 5 percent of your monthly income. So if you make $ 4,000 per month and your auto loan still has six payments at $ 500 per month, you will only be making $ 300 per month.
- Income of $ 4,000 * 0.05 = $ 200
- Payment of $ 500 – $ 200 = $ 300
If you are about to qualify, paying off a debt in installments in less than ten remaining installments can be a good strategy for loan approval.
Income counted in DTI
Your income includes all of your gross monthly income including investment income, interest, rents and anything that is stable and should last for at least three years. Part-time or overtime earnings also count if you can document a history of those earnings over two years.
If you are self-employed, however, this is your taxable income, plus some adjustments like depreciation, which lenders use. So if your business is earning $ 300,000 per year and you have $ 250,000 in write-offs and $ 20,000 in amortization, the lender credits you $ 70,000 in income.
- $ 300,000 gross – $ 250,000 write-offs = $ 50,000
- Add $ 20,000 in depreciation (because it’s not a cash expense), and you get $ 70,000
Calculation of DTI
Suppose you have the following situation:
- Gross salary (before taxes) of $ 72,000 per year ($ 6,000 per month)
- Interest and dividends of $ 6,000 per year ($ 500 per month)
- Total income: $ 6,500 per month
- New monthly house payment: principal and interest: $ 1,200, property taxes: $ 250 and home insurance: $ 50, totaling $ 1,500 per month
- Two auto loans: one is $ 300 per month and the other is $ 200, for a total of $ 500
- Credit card balances with minimum payments of $ 175 per month.
- Total debt payments: $ 2,175 per month, including new housing costs
- DTI = $ 2,175 / $ 6,500 = 33.46 percent
Go further: it is possible with compensating factors
The debt to income ratio of FHA home loans can be extended to a DTI of up to 50%. However, you will need “compensating factors”, which offset the risk of higher debt. Lenders check many dynamics before approving a mortgage, such as your employment history, credit rating, and loan-to-value ratio.
The FHA guidelines mention specific factors that can compensate for a high DTI, but borrowers with a credit score below 580 are limited to a DTI of 43% regardless of the compensating factors.
If your score is 580 or higher, you may be eligible for a loan with a DTI of 47% to 50%. However, having any of these additional qualifications may guarantee you a larger loan than you would otherwise qualify for.
- Cash reserves equal to at least three mortgage payments
- FICO score of 680 or more
- Document future income potential – if you’re a recent college graduate, for example, in a lucrative field
- Minimum increase in your housing payment after purchase – no more than $ 100 or a five percent increase, whichever is lower
- Buying an Energy Star home, lowering your monthly utility costs
- Significant additional income from bonuses, commissions, part-time work or overtime not reflected in your actual income. This may be because you have less than two years of documentation
- If you are moving and have a working “spouse in training” who has not yet found a job in your new location, assuming your spouse is considering working
- Document a savings model, showing regular deposits to a savings or investment account
- Make a larger down payment, like five percent instead of 3.5 percent
- Use credit wisely
Note that the FHA allows lenders to use compensating factors to extend the DTI. It is not require them to do it.
Why you should aim for a lower DTI
If your lender approves you with a high DTI, that doesn’t necessarily mean you have to spend up to your limit. Using half of your gross monthly income for the minimum required payments leaves you with little money in an emergency. And your lender hasn’t factored in expenses like child care that can really hurt your cash flow.
Be sure to budget for basic items like food and clothing, insurance and childcare, and save for emergencies and long-term goals.
In the past, guidelines recommended that homeowners spend a maximum of 28% of their income on housing costs. Lenders have recommended a maximum DTI of 36% on all debt. If your monthly income is $ 10,000, there is a big difference between spending $ 3,600 on your mandatory expenses and a 50% DTI of $ 5,000.
What are the mortgage rates today?
Mortgage rates today are still very affordable, which helps keep your DTI low. You can get your rate even lower by choosing products like hybrid ARMs, fixed for three, five, seven or ten years, and aggressively buying your loan.
This means getting quotes from several competing lenders and choosing the one that costs you the least.
Check your FHA loan eligibility (June 29, 2021)