When it comes to purchasing a home, it can be challenging to understand how mortgage companies will view our financial situations in order to make lending decisions. Having a better understanding of this going into the home buying process is very helpful. So, let's take a look at how lenders view debt versus income.
Debt, Income, Cash... oh my! When looking at these variables the lenders consider each by itself, then again as part of the overall picture. In short, lenders consider usable income, balanced with overall debt and down payment cash, determine the home price a buyer can afford.
Income is considered a person's documented monthly gross income, based on her/his Federal tax returns and W-2, 1099, or K-1 earnings statements.
Some income tax deductions can be added back in to Adjusted Gross Income (such as depreciation and mortgage interest when itemizing, and the Standard Deduction when not itemizing) while others must remain as deductions when calculating qualifying income (unreimbursed business expenses for example).
Generally the more a person deducts when itemizing, the less that can be used as qualifying income. If planning to buy a house in the next year or so, it may make sense to not take a few deductions, show more income, pay a little more in taxes, and qualify for more house. NOTE: Buyers should check with their tax professionals for applicability to specific situations.
Lender's consider accounts the applicant is responsible for paying each month.
Debt would include credit cards, car loans or leases, mortgages on other properties (with taxes and insurance), child support, student loans, and all other financial obligations. Most of these show up on the credit report. Basically all Revolving, Installment, and court-ordered accounts for which the applicant is responsible.
It's important to understand that things like utility bills, cellphone and cable TV bills, and other monthly incidental payments are NOT included in this Debt total. Those payments are considered paid outside the DTI (Debt to Income) ratio allowance described below.
Before applying for financing, it is a good idea to pull your own credit reports to check for inaccuracies and errors.
Cash is defined as readily available money used to complete the transaction. This needs to be assets that are quickly liquid (available to turn into cash in a short turnaround time)
At closing, buyers need to pay any remaining down payment not covered by their contract deposits, along with title company or attorney charges, tax and insurance escrows, and local transfer taxes and recording fees. This must be the buyer's own money from earnings and savings, not a loan from an outside source.
Even before closing, there are costs that need to be paid out-of-pocket. These include the first full year's homeowners/hazard insurance premium, home inspection, Appraisal, and credit report. These costs may be put on credit cards, though that may put the DTI out of balance (see below).
In PreApproval and qualifying, lenders verify the amount and source of buyers' liquid funds available for down payment and closing. Gifts of down payment money from family members are allowed in many loan programs, and seller contributions to closing costs can help buyers who are a little short on cash. You should speak with your lender in advance to find out about any limits to gifts. Also, keep in mind that they usually do a look back to see where deposits come from. NOTE: Different loan programs have different guidelines on this, so be sure your buyers explore all options.
Money from buyers at closing must be by bank wire transfer - NO actual cash, personal, or even certified checks. The closing title company or attorney sends wire instructions to buyers.
The DTI Ratio (Debt-To-Income)
When figuring out what the buyer's monthly housing expenses will be, lenders include the new property's PITIA (Principal, Interest, Taxes, Insurance and Association) :
- loan principal and interest
- property taxes
- homeowners / hazard insurance
- community or building association dues
Then they include the other monthly recurring debts that we mentioned earlier and were verified on the credit report :
- credit cards
- car loans or leases
- PITIA for other properties owned
- student loans, child support, alimony, etc.
This gives the lender the borrower's total monthly debts, which are used to determine the DTI or Debt-To-Income ratio.
Total Monthly Debts ÷ Usable Monthly Gross Income = DTI
Lower DTIs mean there is more income left each month after paying bills, so greater ability to pay a new mortgage along with those bills. Less risk to lenders. Think of it like golf scores... the lower the better when it comes to lending risk. Most lenders like to see overall DTI under 45%
Income and Debt must remain in balance for a buyer to be PreApproved or qualify. When either one changes, DTI also changes. Sometimes it doesn't take much of a change to push DTI past an allowable limit.
Same debt ÷ more income = lower DTI | More debt ÷ same income = higher DTI
Keep in mind that all 3 (Income, Debt, and Cash) contribute to qualifying. A buyer may have good income and low debt, yet if there isn't enough available cash for down payment and closing, that buyer will have difficulty qualifying.
It's always better to address any issues and do some balancing before being faced with contract dates. If you plan to use financing to purchase your next home, take the time to educated yourself and learn about your options early in the looking stages by doing a credit review and talking to a lender in advance.