A survey by FICO, the most popular credit scoring system, says the top reason homebuyers get denied is due to debt-to-income ratios, not credit scores.
It’s rare to get a direct view into how lenders see borrowers. When researchers asked a representative sample of what single factor in an application makes them most hesitant to fund a loan request it’s surprising that credit scores are secondary to the amount of debt carried by borrowers.
Homebuyers typically focus on having good credit scores and a sufficient down payment when seeking a mortgage. But nearly 60% of risk managers in the FICO study rated excessive debt-to-income ratios as their No. 1 concern factor.
With new insight on the importance of debt-to-income ratios, homebuyers can make an adjustment to increase chances of getting approved.
Why Debt-to-Income Ratio is Important
Lenders calculate debt-to-income ratio (DTIs) to ensure you have enough income to comfortably pay for a new mortgage while still being able to pay your other monthly debts.
Lenders will analyze two components of debt-to-income ratios:
1. Housing ratio or “front-end ratio”. The anticipated monthly mortgage payment plus other monthly costs of homeownership like monthly housing expenses, homeowner association (HOA) fees, property taxes, mortgage insurance and homeowner’s insurance will be measured against your gross income from all sources before taxes.
Lenders like to see your housing expense ratio come in at no higher than 28% of gross monthly income. In some instances there is flexibility to go higher if other elements of your application are viewed as strong. In May, according to mortgage software and research firm Ellie Mae, the average borrower who obtained home purchase money through investors Freddie Mac and Fannie Mae had a housing expense ratio of 22%. Federal Housing Administration-approved borrowers had average housing expense ratios of 28%.
2. Total debt ratio or “back-end ratio”. In addition to calculating your housing ratio, a lender will also analyze your total debt ratio. This includes all your recurring monthly debts like monthly expenses, credit cards, auto loans, student and personal loans, alimony and child support. The lender will add up all monthly installment and revolving debts in addition to estimated monthly mortgage payment and housing expenses and divide that number by monthly gross income.
Under federal “qualified mortgage” standards that took effect in January, your back-end ratio maximum generally is 43%, though again there is wiggle room case by case.
Most lenders making loans eligible for sale to Fannie or Freddie prefer not to see you anywhere close to 43%. In May, according to Ellie Mae, the average approved home purchase applicant had a back-end ratio of 34%. The average back-end ratio for FHA was 41%. The average for denied applications was 47%.
Homebuyers may qualify for a non-conforming loan if they have higher back-end ratios. A non-conforming loan does not conform to purchasing guidelines set by Fannie Mae and Freddie Mac. Generally non-conforming loans are considered riskier, and a borrower typically has to pay more than they would for a conforming loan.
To improve chances of approval at a good interest rate work on your debt-to-income ratios, front-end and back-end, before applying. You may have to postpone your purchase until your DTI won’t be rejected.