Debt-to-income ratio is one of the big three factors in mortgage approval.  Incomes have increased across the board recently, but not as quickly as costs have been rising.  With increased interest rates and property values, many clients are now facing a debt-to-income ratio squeeze.

When it comes to mortgage approval debt ratio is a black or white issue.  Either the debt ratio fits within the allowed guidelines or it does not.  There is no gray area that allows for a manual approval is just slightly above the limit.  Different loan program’s do allow for higher or lower ratios.  For example, FHA will allow for a higher debt ratio than a conventional or jumbo loan.

Once pre-approved through a mortgage broker, they will be able to review your options based on debt ratio.  It is possible that your debt ratio is too high for a conventional loan but fits nicely into an FHA loan.  There are times, though, when your current debt ratio will not fit into any guidelines.

What are my options when ratio’s don’t fit?

If debt ratios are too high to fit into guidelines, your broker will analyze how far away you are from current guidelines.  In cases when you are within striking range, there are options that can be considered.  The first option is to see if you have any low balance credit card debts that can be paid off.

When calculating your debt ratio, the lender will look at the minimum monthly payment on any revolving debt.  For example, your credit card has a $3,500 balance with a $125 minimum payment.  Each month, you pay $325 on the account (great job – you are paying that balance down!).  Underwriting will only consider the minimum payment ($125) in your debt ratio.

In some cases, there may be some revolving accounts on the credit report with small balances that can be paid off at closing.  Paying off just a few small accounts can reduce your ratio just enough to get an approval.  Eliminating some small accounts works when you are just above the limit at the start.

Paying a few small accounts isn’t enough – now what?

If a client is still above the limit with paying off just a few small accounts – we need to go bigger.  It gets trickier, in most cases, once we need to pay off larger balance revolving credit accounts.  Many clients, don’t have extra funds laying around that can be tapped to pay down debt.

In a purchase transaction, most clients need any extra available funds for closing.  It is also best to have some extra funds set aside after closing.  There are always unexpected costs that pop up after a home purchase.  Unfortunately, though, it can sometimes be a Catch 22.  If debt ratio doesn’t work, having the extra funds for closing doesn’t matter.

The Gift Funds Work Around

Lenders will allow Gift Funds for down payment and closing costs.  Gift Funds can come from  family member or a close friend.  Gift funds can also be used to pay off debt to qualify.  The lender will need to verify gift funds.  Often with just a little bit of Gift Funds going toward debt repayment helps reduce debt ratio.

I was always told that I should put as much down as possible when I buy a home

The twenty percent down payment requirement on a home purchase is a persistent myth that won’t go away.  I have been in the mortgage business, origination loans for 25+ years.  In all that time there have been low down payment options.  The low down payment options allow a homebuyer to put as little as 3%-3.5% down.  In all that time, though, I repeatedly have conversations with first time homebuyers that believe they need a 20% down payment.

A twenty percent down payment is a great goal.  In some scenario’s it definitely makes sense to put a large down payment.  If you are starting out with an expectation of putting 5% or more down, but have debt ratio issues – we may have a simple prescription.

In the scenario with a 5%+ down payment with a high debt ratio, your broker will calculate how much debt can be paid off at the minimum down payment amount.  Paying down revolving debt by $1,000 goes significantly further than an additional $1,000 down payment.

Although mortgage rates have increases in early 2022 – historically they are still very low.  With these low rates, your total monthly housing payment is minimally impacted by a few thousand in loan amount.  Let’s look at an example.

Purchase price                $275,000

Down payment 10%      $   27,500

Loan amount                 $247,500

Let’s use an example interest rate of 5.5% on a 30 year fixed.  This rate is just for illustration and well above the current mortgage rate.  In this scenario:

monthly principal & interest     $1,405

monthly mortgage insurance   $      44

Under the same scenario with the down payment reduced to 5% ($13,750)

Purchase price                $275,000

Down payment 10%      $   12,750

Loan amount                 $261,250

monthly principal & interest     $1,483

monthly mortgage insurance   $     63

The total difference in monthly payment is only about $100.  Eliminating $13,730 in revolving debt will save much more than $100 in real monthly payment and help reduce debt ratio.  This difference in debt ratio can make the difference in getting approved and closing on your home!

The calculations above are example only.  Interest rate, monthly payment and monthly mortgage insurance was calculated with a 740 + credit score.