When you buy a home with a mortgage, underwriters (human or software) look at your credit, assets, down payment, and income. Most online mortgage prequalification calculators also look at your income and determine how much you can afford to spend on a home. They do this by calculating your debt-to-income ratio, or DTI.
DTI is calculated using two pieces of information – your total household income (before taxes), and your total monthly obligations (including your proposed housing payment). To calculate DTI, take the total of all monthly accounts (for example, your proposed mortgage payment, property taxes and insurance, HOA dues, car payment, student loan payment, and credit cards – but not utilities or other living expenses), and divide that by your gross income. So if you have $800 in monthly payments plus the $1,000 in housing expense, your back-end ratio equals $1,800 / $5,000, which is .36 (36 percent).
If you ever hear a loan officer or broker say that you have an ugly back end, he or she is talking about this ratio – not the shape of your behind! Recent mortgage reforms require mortgage lenders to put more emphasis on DTI ratios than ever before. It’s called Ability to Repay or ATR, and it requires lenders to make a good faith effort to make sure you can afford your loan.
Many lenders set their maximum DTI at 43 percent for conventional (non-government) loans. However, programs like FHA, USDA and VA home loans often allow higher ratios if the underwriter can justify the decision. And some portfolio lenders like LendSure allow DTIs as high as 50 percent.
Stretching Your Ratios
In most cases, to be counted, income should be reliable — that can mean that you must have received it for a year or two and will continue to receive it for at least three years. The exception is pension or Social Security income, which you can count as soon as you start getting it. If you have a solid work history and have a new job in the same field, your income will be counted. If you have no work history and are new on the job, you’ll have problems showing that your income is stable and continuous.
Here are other sources of income that you might not have considered:
• Alimony or child support
• Automobile allowance
• Boarder income (must show on tax return)
• Capital gains income
• Disability income — long-term
• Employment offers or contracts
• Employment-related assets as qualifying income
• Foreign income
• Foster-care income
• Interest and dividends income
• Mortgage credit certificates
• Mortgage differential payments income
• Non-occupying co-borrower income
• Notes receivable income
• Public assistance income
• Retirement, government annuity and pension income
• Royalty payment income
• Social Security income
• Temporary leave income
• Tip income
• Trust income
• Unemployment benefits income
• VA benefits income
In addition, underwriters usually “gross up” non-taxable income. That means you get credit for more income because your source is tax-free. If you’re in a 25 percent tax bracket, for example, and receive get non-taxable income from muni bonds or child support, that income is considered to be 25 percent higher for underwriting purposes.
Even if your extra income can’t be “officially” counted — for example, you have a second job but have only had it for six months — it can be considered a compensating factor in many cases. If you have enough compensating factors, you get to stretch your ratios a bit.
Other compensating factors include low use of debt, a regular saving habit, buying an energy-efficient home, having a job with excellent prospects and documenting extra “unofficial” income, such as commission income that you haven’t been getting for the required two years. That’s why, even if you know you can’t “officially” count some kinds of income, it’s smart to document its existence anyway.