Understanding Debt to Income Ratio
The idea of getting turned down for a mortgage is anxiety-producing for many people. Despite having risen significantly in the past few weeks, mortgage rates are still somewhat low, and so increasingly, people are looking to jump into the market before they go much higher.
That leaves them wondering whether or not they’ll be approved.
Only around 8% of mortgage applications were denied in 2020, according to a NerdWallet study. However, there were 58,000 more denials in 2020 than in 2019. Some of that was due to the uptick in applications in 2020.
So what was the number one reason for denials?
The Leading Reason for Mortgage Denials
The most common reason mortgages are denied because of what’s described as an unfavorable debt-to-income ratio or DTI. Data shows that DTI is the reason for 32% of all denials.
That’s not necessary a new phenomenon either.
The debt-to-income ratio is a historical reason for mortgage denials, followed in second place by low credit scores. Low credit scores make up around 26% of mortgage denials.
What is Your DTI?
Your debt-to-income ratio is a calculation of all of your monthly debt payments. Those are added together and include credit card payments, auto, personal and student loans, child support, and your current mortgage. Once those totals are added together, it’s divided by your gross monthly income.
Most lenders want borrowers with a DTI at or below 36%, although there can be some variance.
If you were to earn $7,000 in gross monthly income and your monthly debt is $2,500, this would be a DTI ratio of around 36%.
So why is DTI so relevant to lenders?
Lenders want to see the amount of debt a customer can take on before they start to have trouble paying it.
The DTI is how they set the amount they’re willing to lend based on what you’re reasonably able to afford.
Lenders see the DTI as a very strong risk indicator. If you have too much debt or insufficient income, you’re not an ideal borrower in the eyes of a lender. At least in their perception, you’d be adding another payment to a budget already stretched thin.
What To Do If You’re Denied Because of DTI
If your DTI is higher than 36%, there are things you can do.
First, you need to figure out a way to reduce your monthly debt payments. It’s optimal if you can also increase your income.
As you’re starting to deal with a problematic DTI, begin by first taking on your highest-interest debt. This usually includes things like credit cards. Then, you can move on to any personal loans or car loans.
There are multifaceted benefits of taking steps to improve your DTI. For example, when you’re paying off debt, you’re also potentially raising your credit score and freeing up some of your income.
The other big factor for denial, as mentioned, is a low credit score.
Before you even start thinking about applying for mortgages, check your credit report to know what you’re working with. You need to see your score and know that lenders will assess your history of payments. Lenders tend to like to see scores that are 760 and higher to offer the most competitive interest rates. Of course, DTI and credit score aren’t everything you need to get approved for a mortgage. You also need cash reserves and down payment, and proof of income.