One of the most common problems people have qualifying for a personal house or investment property is a high debt to income (DTI) ratio. Most lenders will want to see a debt to income ratio of 45 percent or lower. If your debt to income ratio is higher than this, it will be very hard to qualify for a loan. I have investors emailing me all the time and asking on the Invest Four More discussion forum how to get around high DTIs. Even my portfolio lender who is very lenient with lending requirements will not lend to people with high debt to income ratios. The options to reduce your debt to income ratio are to make more money or pay off debt.
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What is debt to income ratio and how is it calculated?
The debt to income ratio is calculated by taking your monthly debt payments and dividing them by your gross income before taxes. If you have $2,000 of monthly debt and $5,000 of gross income you would have a debt to income ratio of 40 percent ($2,000/$5,000 = 40%). That is a very simple equation, but it is not always simple coming up with the monthly debt and income, especially if you own rental properties.
You must count the property mortgage payment against your debt to income ratio. Even though your debt to income ratio may be 35 percent right now, a new mortgage payment may push that number to 45 percent and you may not qualify for the mortgage. The DTI will generally be the deciding factor on how large of a loan you can qualify for. The most payments you can qualify for on a new mortgage would be the payment that pushes you to the maximum debt to income ratio a lender will allow. If a lender will allow a 40 percent debt to income ratio and a $1,000 house payment pushes you to 40 percent, that would be the highest payment you could qualify for. (I am using different maximum DTIs, because different lenders and programs allow different DTIs)
It is your monthly income and monthly debt payments that the banks pay attention to, not total balances. If you have a $2,000 credit card balance, it may not seem that would affect your ability to qualify for a loan. But if your payments are $200 a month that would have a huge impact on how high of a mortgage you can get. A $200 dollar a month difference in mortgage payments can reduce the amount you qualify for by as much as $40,000!
What expenses and income are included in DTI?
If you are applying for a loan, everyone who will be on the loan will have to include these figures in debt:
- Minimum credit card payments
- Auto loans
- Student loans
- Consumer loans
- Other financial obligations including child support and alimony
- Your current housing payments do not count if you are going to sell the house before you buy the new house. If you are keeping the house you will have to count the payments as debt.
- Your estimated future housing expense, which includes principal, interest, taxes, insurance, and any HOA fees.
To calculate your income you use:
- Your gross monthly salary before taxes, plus overtime and bonuses. Include any alimony or child support received that you choose to have considered for repayment of the loan.
- Any additional income like rental property profits. This is tricky because some lenders will not count any rental income until it shows up on your taxes. Other lenders will count 75 percent of your rental income if you are an experienced investor or have the house leased.
Usually it is a little tricky calculating the debt to income ratio, because different banks calculate things differently. It is best to let whatever lender you are using calculate the DTI for you. If the bank comes up with a DTI that seems very high, double-check how they calculated it to see if they are doing something strange or put a wrong number in somewhere. Some banks will count depreciation of investment properties against you, even though that depreciation is not a monthly expense. I describe how depreciation works on rental properties in this article.
Why do different banks use different debt to income ratios to qualify you?
Different banks use different DTIs and different loan programs use different DTIs. VA and FHA typically limit borrowers to a 41 percent DTI, but in some circumstances may increase that percentage slightly. Fannie Mae allows up to a 45 percent DTI on some loans, but you must have great credit. With credit scores under 700 you typically would have to have your DTI under 36 percent.
As you can see this can all get very confusing trying to figure out yourself. Here is a link to the Fannie Mae lending matrix which is even more confusing. The best thing to do is to talk to a lender and if your DTI is high, work on lowering it.
How can you lower your debt to income ratio?
The easiest way to lower a debt to income ratio is to make more money. The more gross income you make the higher your DTI will be, but that is not the only thing lenders look at. It is not easy to simply start making more money, but many investors and self-employed individuals or business owners claim very little income on their taxes. Claiming little income is great if you don’t want to pay much in taxes. If you want to qualify for a loan, claiming little income can make it nearly impossible to buy a house. You may think you are making $10,000 a month, but if your taxes show you making $2,000 a month your DTI could be much higher than you think. Claiming more income on your taxes will mean you have to pay the IRS more, but it may be worth it to be able to buy a house.
Reducing debt is another way to improve your debt to income ratio. Debt to income ratios take into consideration all monthly debts that show up on your credit report. Usually the shortest debts hurt you the most, because they have the highest payments. Even though you think you are doing the smart thing by getting a 15 year loan instead of a 30 year loan on your primary house, it actually will hurt your DTI ratios. A three-year loan on a car will make your DTI higher than a six-year loan. I am not saying you should always get the longest term possible on debt, but the lower your minimum payments are, the lower your DTI will be. You can always make extra payments if you want to pay off your loans quicker.
- Minimum credit card payments: credit cards typically have very high interest and very high monthly payments. If you can pay off credit cards it will greatly improve your DTI, but you must pay off the entire balance.
- Auto loans: car loans can destroy a DTI! A $600 car payment is equivalent to a $120,000 mortgage and will reduce your ability to qualify for a mortgage by $600 a month. Do you need to have a new car every three years if it means you can’t buy a house?
- Student loans: Student loans may have low interest and low payments, but they still hurt DTI. I think it is usually better to pay off other debt first.
- Consumer loans: Do you have a loan for a TV, furniture, home equity line of credit, or any other monthly payments that show up on your credit? Even a home equity line of credit that you are not using can count against your DTI.
If you don’t have the money to pay off your debt, you may be able to consolidate it with a larger loan against your home that would have a lower interest rate and monthly payment.
What is the best way to pay off debt?
If you have a lot of credit card debt, car loans and consumer debt, the best idea is to pay off one at a time as quickly as possible. The payments will stop affecting your DTI once they disappear off your credit. That is why paying off one at a time will improve your DTI quicker, much like the snowball method for rentals.
When you pay off one debt, you can use the money you were spending on those payments to pay off the next debt quicker. I would pick the debt with the lowest balance compared to the highest payment to pay off first. If you have a $2,000 debt with $200 payments, I would pay that off before you paid off a $5,000 debt with $300 payments. You will pay off the $2,000 faster and then be able to use that extra $200 a month to pay off the next debt and so on.
If you have a huge car payment, don’t be afraid to sell the car and buy a cheaper one. I may own a Lamborghini now, but I have never bought a new car. My daily driver for ten years was a 1991 Mustang that I bought with cash.
Be careful when you buy a personal residence
If you want to buy rental properties, be careful when you buy a house for yourself. Many lenders will tell you how much you can qualify for, not how much you can afford. Buying the most expensive house you can afford, means you probably cannot buy investment properties. Try not to spend all you money on your personal house, because it also makes it very hard to save money as well. Here is an article with much more information on how much you should spend on your personal house.
There is no magic way to reduce your DTI, it usually takes making more money or lowering your monthly debt payments. There are a few lenders that do not consider DTI, but they are usually lending high dollar amounts on large investment properties or many investment properties at once. If you find yourself with a high DTI, talk to your lender, make sure they are figuring everything correctly and concentrate on reducing your monthly debt payments.