Understanding Debt-to-Income Ratio for BMR Home Loan
Lenders look at a variety of factors when deciding whether to grant borrower approval and at what interest rate. In addition to your credit score, employment status/history, and income, mortgage companies prioritize prospective clients with a low debt-to-income (DTI).
We always recommend meeting with a financial counselor to get an accurate portrait of your DTI, which you can do using resources through Homeownership SF.
Calculating Your Debt to Income (DTI) Ratio
A low debt-to-income ratio means that a borrower lives reasonably within their own means. The more total debts you have against your income, the lower that ratio is, and the less creditworthy you appear to prospective lenders.
Remember: Banks assume a risk anytime they lend money. If borrowers default on a loan (stop paying it back), there is only so much recourse a lender can take, and they lose the initial investment. So, while there is no guarantee of whether or not a borrower will successfully repay the loan, there is a higher chance of that with certain pre-requisite verification in place.
Typically, lenders perform comprehensive reviews of a prospective borrower's:
Overall credit score.
Current employment and prior employment history.
Income tax history for two to three years (or more, especially for self-employed loan applicants).
Monthly/annual income.
Bank accounts (balances and statements).
Verification of other assets.
Debt-to-Income ratio.
Debt-to-credit ratio (different from your DTI).
Once banks have all of the above information, they gain a better idea of whether investing in (lending to) that person makes sense. For lenders, establishing a person's debt-to-income ratio is the financial equivalent of a physician taking their blood pressure or doing a blood panel; it provides valuable insight into their financial health.
How To Calculate a Person's DTI Ratio
To calculate a person's DTI ratio, lenders divide the total monthly debt payments they pay every month by the total of their monthly income. The resulting percentage is the DTI score. Banks are more apt to approve a loan at the lowest interest rates available for people with DTIs of 42% or lower. If your DTI is 43% or higher, odds are you'll have a harder time getting a loan. Or, if you are approved for a loan, it will be at a significantly higher interest rate than it would have been with a lower DTI.
Example of a DTI Calculation
Here's a sample DTI calculation:
Regina's gross income each month is $5550. She also receives $750 in child support. So, her total monthly income is $6300.
Her monthly itemized debt payments are:
$2125 for rent.
$450 for an auto loan.
$350 toward her college loan.
$575 on revolving debt from credit cards.
The total monthly debt payments equal $3500.
$3500 ÷ $5550 = 64%.
So, the odds of Regina qualifying for a mortgage loan are slim unless she has a co-signer or is applying for her loan with someone else and their combined debt-to-income ratio meets standard lending guidelines. OR, Regina will need to look at how she can reduce those revolving credit card balances for a better DTI score.
This is why creating a reasonable monthly budget is crucial when buying a home - even if you’re applying for a below-market-rate (BMR) loan. Taking the steps necessary to reduce your DTI while maintaining a high credit score can make the difference between whether you qualify for a home loan - and qualifying for a low- vs high-interest rate.
Which Amounts Count Toward Income vs. Debt Payments?
Prospective lenders aren't interested in a personal story. Rather, they focus on the black-and-white, hard data that becomes part of your credit application process - via credit reports, employer income verification, tax records, and bank statements.
Here are examples of the most common types of income or debt payments used to formulate DTIs.
Qualifying monthly income
Lenders are usually willing to include any monthly income towards your gross income - as long as you provide a legitimate paper trail. Some of the most common income sources that count towards a DTI include:
Salary or hourly wages from work.
Tips that have a paper trail (beyond legal tax obligations, we always recommend claiming tips and cash payment on your taxes as this counts toward your income and boosts your DTI when you're ready to purchase a home).
Child support.
Alimony.
Rents from properties you own.
Social security or disability.
Pension/retirement funds you're drawing on each month (NOT monies invested that you can't get until retirement).
Other non-taxable sources of income with verifiable proof.
All of these income sources support financial stability.
Which debt payments count against income?
Banks don't have the ability to analyze all of your spending habits, so they largely focus on your rent payments (and may require proof of canceled checks or landlord payments posted on bank statements) and payments listed on your credit report, such as:
Mortgages.
Car loans
Student loans.
Lines of credit
Personal loans.
Medical installment payments.
Any other loan payments
These debt obligations are all factored into final DTI ratios. NEVER take on any new debt (like buying a car or using 0% interest financing offers) when trying to minimize your DTI.
Bills that are usually not factored into a DTI include:
The money you spend outside of reported credit card debt.
Gas, car insurance, and other car expenses.
Groceries.
Utilities.
Again, if it doesn't show up as part of your credit history, it probably won't be counted as part of your DTI calculation.
As you work to raise a DTI before applying for a loan, remember that creditors place a different value on different types of debt. You may have heard of "good debt" vs. "bad debt." It's worth understanding the difference as you work towards becoming a homeowner.
Differences In Types of Debt
Living in the Bay Area makes it increasingly difficult for hardworking residents to have a healthy DTI. The cost of living is so high that even with an excellent income, a basic rent or mortgage loan payment means there's a good chance that your DTI will be close to or greater than the desired 42% or less.
If you want to purchase a home, focusing on a budget and lifestyle that keeps your DTI at a desirable number makes all the difference. This requires understanding the difference between "good debt" and "bad debt" and making responsible, long-term decisions when taking on any new debts.
Good Debt
Mortgage lenders expect the average working person to have some level of debt. However, all debt is not created equal. Good debts should increase your net worth or will increase in value over time. This includes:
College loans
Car loan payments (assuming they're reasonable - more on that later)
Mortgage payments.
College loans mean you have a higher level of education, are more widely employable, and usually increase your earning potential. Without a car, getting a job or having access to higher-paying jobs may be more difficult. So, these debts are not looked at as irresponsible as long as they don't tip the DTI balance out of your favor.
Bad debt
Bad debt represents payments for things that don't increase in value over time or take away from your net worth.
Examples of bad debt include:
High or long-term revolving credit card balances.
Repeat debt consolidation loans.
Payday loans (a sure sign you are spending more than you make).
Even if you make minimum credit card payments each month, carrying credit card or personal loan debts ultimately signifies that you tend to spend more than you earn. Not only does that negatively impact annual credit scores, but continuous revolving credit debt is a red flag to creditors that you don't know how to manage finances responsibly.
Strategies For Decreasing a High Debt-to-Income Ratio
Is your debt-to-income ratio above the 42% maximum? That's okay. There are things you can do to change that around.
1. Create a monthly budget that makes sense
If you're not great with money, think about the people you know. Family members, friends, or co-workers are some of the best free resources when it comes to helping you create a realistic budget. It's time to get out the calculator and get clear about what's coming in and what's going out.
Look at how much you bring in and itemize exactly how much you spend - and for what - each month. Your checking account (and credit card) statements are the best places to start. Taking stock of your monthly finances may shed a glaring light on unnecessary expenses that can be eliminated so you have more available to pay down your debt.
Break spending down into categories:
Student loan.
Entertainment.
Groceries.
Restaurant/fast food.
Coffee.
Gas.
Utilities.
Travel.
Clothes/shoes.
Etc.
The simple practice of dividing spending into categories is a great way to understand which ones are necessary (housing costs and student loans) vs. which could be whittled down or eliminated until you achieve a healthy DTI (entertainment, Starbucks, etc.).
2. Decide whether your car payment is worth it
People love their cars and what their cars say about them. However, if your debt-to-income ratio isn't good enough to qualify for a house, it may be time to downsize/downgrade your vehicle to lower or eliminate the car payment. Paying for a luxury car - or brand-new vehicle - when a decent used model will suffice isn't worth sacrificing homeownership.
Once you've qualified for your loan, purchased a home, and consistently made your mortgage payment (while also having a bit put by for savings), you can set your sights on a new or luxury vehicle again. Until then, keep it as a reward for your practical budgeting efforts.
Again: NEVER take on a car loan when trying to minimize your DTI or applying for a BMR home loan as it can cause lenders to think twice about you.
3. Pay down credit card and other revolving debt
Any debt floating out there due to spending - or overspending - habits needs to be paid down ASAP. The sooner you get those credit cards paid down, the sooner you decrease your DTI.
Things to consider:
Take advantage of your bank's services. Your bank is an excellent place to start, as they may offer tools and resources that support your cause for free - while offering continuing guidance and professional advice.
Using 0% interest offers to consolidate credit card/revolving debt. Consider consolidating existing credit card debt onto a 0% interest card with a fixed payoff window (usually 6 to 12 months, and the longer, the better). In this case, you'd utilize their one-time transfer and migrate debt from your other cards. Divide the total amount owed by the terms of the 0% interest offer, and pay that amount (or more) until you've paid off the total. This can save you hundreds and even thousands of dollars in interest. If you can't afford to do this for all of your debt, decide how much you can afford and transfer debt from the cards with the highest interest rates.
Debt consolidation loan for a longer approach. Debt consolidation loans are typically considered "bad debt." However, if it's a one-time thing and you're disciplined about it, they can be an easy way to clean up debt in single monthly payments. With the debt consolidation model, you add up all of your higher-interest debt and roll it into a lower-interest debt consolidation loan. It's like the 0% interest credit card model, but the low-interest term doesn't run out, so this is best for people with an overwhelming amount of debt.
4. Cut out or reduce the non-essentials
If you get Starbucks Monday through Friday, do the math. There's a good chance you're spending hundreds of dollars per month for that. Instead, treat yourself to your favorite coffee drink once a week - make coffee at home - and put all of that extra money towards eliminating credit card debt.
The same is true for spending on things like:
Dinners out.
Fast food.
Bar nights/alcohol.
Cigarette/vaping habits.
Clothing/shoes/accessories.
Unnecessary travel and weekend excursions
There's a reason we call them spending "habits;" once you get used to spending routines, the habits are hard to break. However, a little discipline adds up, and the savings go a long way. And, if your spending habits include "bad-for-you" habits, that's even better in terms of both the financial and health savings accounts!
5. Consider additional income streams or revenue sources
Is there something you could take on to make extra money each month? You may find that just a few months of taking on odd jobs or working a couple of extra shifts per week generates enough income to help you pay off bad debt. Then you’re freed back up and ready to apply for a BMR home loan with better chances of loan approval success.
Unless taking on a second job - or odd jobs (ridesharing driver, dog walking, pet sitting, seasonal employment, etc.) is sustainable, we don't recommend taking on extra work to permanently increase the "Income" portion of the debt-to-income ratio. There always needs to be a healthy work-life balance. However, if you can work enough to reduce your debt, it's worth a few months of extra labor to qualify for a home loan or to save for a down payment.
Keep BMR Requirements In Mind
If you’re purchasing a below-market-rate (BMR) unit, make sure you keep their requirements in mind. This means:
Knowing and understanding the median income ranges in your area of San Francisco to ensure you qualify (our housing counselors can assist you with that).
Making sure any additional income you bring in to pay down debt keeps you within the income requirements so you don’t wind up disqualifying yourself.
Do not take on any significant debts (we can’t emphasize this enough) so you keep yourself in the healthy debt-to-income ratio margins).
Ready to Lower Your DTI and Become a Homeowner?
Are you ready to change your spending habits, decrease your DTI, and get serious about becoming a homeowner? We'd love to partner with you and make those dreams come true.
The 400 China Basin team works with people like you every day. We have a network of people here to help you get on track, including housing counselors and buyers' advocates. In addition to helping you understand DTI and other factors influencing the home loan qualification process, we put you in touch with products and services that transform renters into homebuyers.
Contact us to learn more about how to get your financial health in shape, so you can purchase stunning Bay Area homes at below-market rates.
