Understanding the Important Debt-to-Income Ratio
How Much Can You Spend on a Mortgage Loan?
Instead of looking at the total amount you can borrow to buy a home, it’s better to consider how manageable the monthly payment is for you. This is because you’ll need to pay this amount every month, so you want to ensure it fits within your budget.
One of the best ways to measure this is through the “Debt-to-Income Ratio” or DTI ratio. It’s generally calculated by dividing monthly debt payments by income. More specifically, it can be measured in two ways:
Front DTI Ratio: This measures your monthly mortgage payment as a percentage of your total monthly income. For example, if your salary is $54,000 a year ($4,500 a month) and your mortgage payment is $1,000, your front DTI ratio is 22% ($1,000 / $4,500).
Back DTI Ratio: This measures your total monthly debt payments, including the mortgage, as a percentage of your total monthly income. If you’re also paying $250 a month for student loans and $200 a month for your credit cards, for example, your back DTI ratio would be 33% ($1,000 + $250 + $200) / $4,500).
Banks use these ratios to determine the maximum monthly mortgage payment you may qualify for. For instance, Freddie Mac and Fannie Mae guidelines state that the back DTI ratio for conventional mortgage loans should not exceed 36%. In other words, your total debt payments should not be more than 36% of your monthly pre-tax income.
Note: Banks consider other factors when deciding to approve a mortgage loan, such as your credit score and the stability of your job.
Rules of Thumb for How Much You Should Spend on a Mortgage Loan
There are many ways to use your DTI ratio to determine how much you should spend on a mortgage payment. For example, there are maximum limits set, but often it’s better to follow a cautious principle to avoid finding yourself in a financial bind – which means your mortgage payments are too high and you’re struggling to meet other expenses.
You and your financial advisor can only determine which simple rules work best for you. Here are the rules people commonly use:
28/36 Rule
The 28/36 rule states that your front DTI ratio should not exceed 28%, and your back DTI ratio should not exceed 36%. In other words, your mortgage payment should not be more than 28% of your pre-tax income, and the mortgage along with all your other debt payments should not exceed 36% of your pre-tax income.
Most banks use this simple rule to determine maximum loan limits when applying for a conventional mortgage, which is why this rule is common. But remember – just because this is the maximum a bank can offer you, it doesn’t mean it’s the best fit for you.
If you have many unknown factors in your life – such as income volatility, potential large expenses in the future, or uncertainties regarding student loan forgiveness – it may be better to choose a more cautious rule. This way, you won’t commit to a high mortgage payment that could be difficult in the future, even if you can manage it now.
Model
25% After Taxes
A more cautious rule is to limit your monthly mortgage payment to 25% of your after-tax income (i.e., what you see in your bank account).
For example, if your salary is $54,000, you might actually see around $2,900 per month as net income. If you set your monthly mortgage payment at 25% of your salary, that translates to a loan payment of $729 per month. This is well below the maximum mortgage payment of $1,000 that you would be limited to according to the 28/36 rule.
Experts often prefer this straightforward rule because it puts you in a more sustainable position for your mortgage payment. You will have greater flexibility to handle emergencies, save for retirement, and other buying expenses.
DTI Loans at 50%
In some rare cases, you may be able to secure a conventional mortgage with a background DTI ratio of up to 50%. Fannie Mae, for example, allows this for certain types of loans written by special programs.
However, just because you can access a DTI ratio of up to 50%, it may not be wise. With an annual income of $54,000, for instance, your mortgage payment could be as much as $2,250 per month when you only have around $2,900 per month after taxes. It’s a dangerous place because you will not have cash flow to handle any emergencies or additional savings.
How to Use DTI Ratio to Determine How Much House You Can Buy
Targeting a good DTI ratio for you can help you plan the size of the mortgage you will take out and ultimately the type of home you will look for. Once you know the monthly payment you can afford, you can use a mortgage calculator to determine the loan amount available and the down payment you could obtain with that monthly amount.
For example, if you use the 25% after-tax rule and have a monthly income of $5,000, that means committing to a mortgage payment of $1,250. Using the slider on a mortgage calculator, you can see that this means you could afford a home worth $233,000 if you made a 20% down payment.
Frequently Asked Questions (FAQs)
What is the highest DTI ratio for a conventional loan?
The highest DTI ratio you can have with a conventional loan is 50%. However, most banks will set a DTI ratio limit of 36%.
How much debt should I pay off before buying a house?
It’s best to pay off as much debt as possible, but you also need to balance the need for a down payment. At a minimum, you’ll need to pay off enough debt to afford the mortgage payment while staying under a 36% back-end DTI ratio if you’re looking for a conventional mortgage.
What is the ideal front-end debt ratio?
While recommended front-end ratios vary based on simple rules, a “good” front-end ratio will depend on your situation. For you, this might mean that you can afford to pay for and live in a home you love while allowing you to meet your other financial goals, such as saving for retirement, emergencies, paying off debt, and enjoying hobbies.
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Sources:
Freddie Mac. “The Monthly Debt Payment-to-Income Ratio.”
Charles Schwab. “How Much House Can You Afford?”
Chase. “What Percentage of Your Income Should Go Toward Your Mortgage?”
Fannie Mae. “Selling Guide.”
Source: https://www.thebalancemoney.com/how-much-should-you-spend-on-a-mortgage-5210815
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