One of the most important ratios in mortgage qualification is the Debt-to-Income ratio, or "DTI." Understanding DTI and how it is calculated will help you figure out not only how much of a loan you can qualify for, but also how you can maximize the approved loan amount.
The DTI ratio is calculated by taking all of the borrower's monthly liabilities and dividing it by the borrower's monthly income. So in other words, if you have monthly liabilities of $2,500, and you make a monthly income of $6,000, then your DTI would be $2,500 ÷ $6,000 = 41.6%.
Most loan programs have a maximum allowable DTI limit. For Conventional loans, you can generally be approved up to 50%. For USDA loans, you can generally be approved up to 41%. For VA loans, it's generally 41%, but you can be approved up to 60% with compensating factors such as high residual income, excellent credit, or low payment shock.
Keep in mind there are many other factors that go into a loan approval other than your Debt-to-Income ratio. You must meet Credit Score and Report requirements, Loan-to-Value ratios, Seasoning requirements, Borrower Eligibility requirements, and Property Eligibility requirements, to name a few.
The formula for Debt-to-Income seems easy enough...after all, it's only your monthly liabilities divided by your monthly income. However what most consumers don't know is exactly how your liabilities and your income are calculated. Mortgage underwriting splits your monthly obligations into two categories:
Housing Expenses and Other Expenses.
Housing Expenses consist of the expenses pertaining to the property you are purchasing or refinancing, known as the subject property. Only the expenses that you are obligated to pay will be reviewed, which means bills like your cable tv or electricity bill do not count. The Mortgage Payment, Homeowner's and Hurricane Insurance, Real Property Tax, and Association/HOA dues (if any), do count towards your Housing Expenses. Together this is known as PITIA (Principal & Interest, Tax, Insurance, Association Dues).
Other Expenses consist primarily of your monthly payments reported on your credit report. Your minimum monthly payment on credit cards, monthly auto loan or lease payments, monthly student loan debt, monthly payments on other types of loans or lines of credit, and of course, the PITIA on any other properties you own will all count towards your Other Expenses. If your other properties owned are rental properties, then we might be able to offset those housing expenses with the rental income you earn. Note, some expenses that may not show up on your credit report such as private loans, alimony, child support, etc., still need to be included in the calculation.
If you are having trouble qualifying for a loan due to high Debt-to-Income ratios, then your best bet may be to reduce the number of monthly liabilities you have. It may be worthwhile to use some of the money you've saved up for a downpayment and use it to pay off or pay down debts to qualify.
In Mortgage Underwriting, there are generally two categories of income earners: W2 Employees and Self-Employed.
W2 Employee - If you work for a company and you have less than 25% ownership in that company, you are considered a W2 Employee, due to the fact that your income is reported on the IRS form W2. Generally, you earn paychecks on a weekly, bi-weekly, semi-monthly, or monthly basis.
For W2 Employees, your income is calculated by reviewing your paystubs and prior year W2s. Your regular hourly wages or salary is considered "base pay." Other types of income you might earn such as Tips, Overtime, Commission, and Bonus income is not considered "base pay" and requires extra scrutiny. If you haven't earned these types of income for at least 2 years, you might not be able to use it to help you qualify.
Self-Employed - If you own at least 25% of the company, you are considered self-employed for the purposes of mortgage qualification. Rather than look at paystubs, mortgage underwriters will generally look at your tax returns for the past two years and use the income reported to the IRS to qualify. If there are large fluctuations in your earnings, underwriters may ask for a third year of tax returns or a Year-to-Date Profit and Loss statement.