Saturday, November 13, 2010

Do You Have Too Much Debt?

Your Debt to Income Ratio is key to your loan approval. Here's how to beat the system.

Your personal Debt to Income Ratio (DTI) is an important factor all lenders use to determine your credit worthiness. This ratio is essentially what you earn against what you are paying out each month for scheduled debt. If you have a high debt ratio, then your monthly living expenses will usually start to suffer and most people will start missing payments or let their credit balances creep higher. This is murder to your credit rating as all your creditors will see this trend when they view your statistics. Once your balances rise, your credit score dives, and up go your interest rates! So it pays to understand how this works. Literally.

SAVE this Debt Evaluation Calculator link:

Essentially if you are over 30% of your availble credit balance and over 40% of your monthly income going out the door via regularly scheduled debt, you are going to start seeing an impact on your ability to get a mortgage.

Use this handy evaluation tool check it often to keep yourself on track.

It is important to have control of your monthly debt payments against your monthly income. A high debt ratio might indicate that your monthly expenses are becoming unmanageable. A high DTI will discourage lenders from loaning you money.

Quick DTI Example for Monthly Gross Income of $4,000:
Mortgage including taxes and insurance (or rent): $1,000
Car payment: $300
Credit card minimum payments $200
Other unsecured debt: $100  (i.e, a computer or applicance account)
Total debt payments: $1,600 per month
= Total monthly debt ratio of  40%
This is considered acceptable and 'safe' range.

Let's add an item and see what happens
Medical debt or collection account: $400
Total debt payments: $2,000
= Total monthly debt ratio of 50%
This is becoming a bit high and you would be advised to lower it. 

Very few banks would let you borrow to a 50% debt ratio for a home mortgage.

Adding one more item to your home budget:
Student Loan Payment: $400
Total debt payments: $2,400
= Total monthly debt ratio of 60%
This is too high and and considered a risky debt level

Virtually all banks would deny your proposed $1,000 home mortgage payment with a debt ratio of 60%. (A strong compensating factor might be your liquid assets able to service the proposed new debt.)

Why does DTI matter?
In the 60% DTI case above, you still have theoretically $1,600 income available for your use. This amount of  money is likely to be absorbed by taxes and other life expenses with no safety net in case something unexpected comes up. What happens if you have a major car repair or lose hours at work? A person with a 60% DTI is very unlikely to be saving or building up a retirement nest egg.

So unless you are a very careful investor who saves money and has few surprises in life, 60% DTI is considered very risky cost of living. If you happen to have several children and other responsibilities then even 40% could be a stretch for you personally.

How DTI Affects Your Mortgage-Ability:
With a 60% DTI, if you were applying for a mortgage you would expect to be turned down by every bank in town. As a mortgage planner, I would sit down with you and go over your credit report and help you identify what, if anything, can be resolved to assist you to qualify for a home mortgage.

DTI Strategy:
Let's say you wanted to buy a home within three months. If you have 6 months left on your car payment and it can be paid down to under 3 months - that really helps. (We can remove debts that are under 90 days to be paid off with good payment history).

In addition, if you paid off your credit cards and removed that $200 payment, you are again, improving your DTI. You might have a bonus coming at the end of the year that could be used for this purpose. If you can make a 3 month car payment (to bring your car loan under 90 days pay off) that would improve your ability to finance a home purchase today. Or we might decide to target your home purchase time frame within three months. Three months is a good time frame to be shopping for a home while you are improving your debt ratio, which by the way will also raise your FICO score.

At that point, if all other issues including your credit rating and history and income are acceptable, you would likely qualify for a $900 home mortgage payment for a total debt ratio of 45% or $1,800 per month expenses.

Note: Student Loans may be in 'deferred status' until you start working and once you are working and paying them -- usually at very low interest rates. If your student loans are in deferred status they may still be counted against your ratio - as you will be responsible for those payments eventually. Usually your student loan is not something we would target to pay off early, since credit cards and car payments generally have higher interest rates.

Why Does Your Bank Care about DTI?
Underwriters will ask many questions during a loan application if you are on the edge of your ability to make payments over the 45% DTI target zone. If you are under this range, and show good history of making your payment on time, you are showing responsible ability to manage your debts. You are most likely already enjoying a good credit score and will also benefit from a very good interest rate offer.

A bank's number one concern is your ability to make your payments on time. Factors like DTI and FICO score are their top tools to determining if your application meets the Fannie Mae, Freddie Mac and specific investor guidelines.

Use these simple rules to your advantage!

© 2009 susan templeton