“Those that fail to learn from history, are doomed to repeat it.”
Those famous words, often incorrectly attributed to the late British Prime Minister Winston Churchill (Spanish philosopher George Santayana actually coined the phrase), are applicable to today’s mortgage meltdown. Four years after the stock market began to crumble, sending millions of American homeowners into underwater mortgages and foreclosure, it seems as if we’ve forgotten the lessons we’ve learned from sub-prime loans and unaffordable mortgages. Case in point? Today’s debt-to-income ratio.
In case you’re unfamiliar with the concept, the debt-to-income ratio, or DTI, is one of the critical benchmarks in the home loan application process. In order to qualify for today’s ultra-low mortgage rates, banks want to see your DTI fall under a certain percentage.
Do you want the good news or the bad news first? I’m a glass half-empty kind of gal, so you’re going to get the bad to start. The first part of the debt-to-income ratio is the debt. It includes things like:
- Student loan payments
- Existing balances on your credit cards
- Car loans
- Personal loans
- Child support or child care costs
- Alimony or other forms of spousal support
- Your mortgage, including escrow
Moving on to the good news – or at least, hopefully, the better news: your income. For the DTI ratio, you need to supply your gross income. This is the total amount of money you earn: before taxes, before 401(k) contributions, before deductions. Be careful not to confuse gross income with your net income, or “take home pay.”
There are plenty of online tools that will help you to calculate debt and your gross income. I, however, prefer good old pen to paper, and like using the downloadable worksheet from the NeighborWorks America website.
Calculating Your Debt-To-Income Ratio
Since mortgage lenders break your loan down into monthly payments, you want to do the same when calculating your DTI. Take your total annual debt (d) and divide it by 12. Do the same for your gross income (i). Now, divide them, so:
d / i = DTI
For example, say your household’s gross income is $50,000; dividing it by 12 gives you “i,” or $4167 (I rounded up to the nearest dollar). But you also carry $20,000 in annual debt, which is equivalent to $1667 in monthly debt. So your total DTI is:
$1667 / $4167 = 0.40
Making Sense Of Your Debt-To-Income Ratio
Now that you’ve got your number, what does it actually mean? It depends on who you ask.
Different banks use different DTIs to determine whether or not to approve you for a mortgage. Some lenders, like Wells Fargo, where I do my banking, allow you to have a DTI as high as 41 percent; FHA loans carry the same DTI guidelines. Other lenders want to see a far lower DTI – ideally no higher than 38 percent – in order to give you the lowest mortgage rates.
Breaking Down The Numbers
A debt-to-income ratio of 40 percent, like in our example above, doesn’t sound all that bad. After all, it means you have 60 percent of your gross income available for non-debt related expenses. But when my husband and I sat down with our mortgage broker to discuss our application for a new loan, I was startled by the figures.
Here’s the nitty gritty of my family’s finances:
- Gross income: $54,328 for for 2011, or $4527 a month
- Total monthly debt: $1350 (this includes $951 for our mortgage, including escrow, $140 for my student loans and $259 for our only existing car payment)
- Our DTI is: just shy of 30 percent
Sounds like we’re in the clear, right? Even when we talk about upgrading to a larger home – thanks to today’s low mortgage rates – our monthly debt would only increase by $250, changing our DTI to 36 percent – considered an ideal ratio by many lenders. Hooray, I’ve approved our loan application!
Not so fast, Libby… (That’s my mega-frugal conscience speaking.)
While our gross income is $4527 a month, my husband and I take home far less than that. Take out money for taxes, our flexible spending account for health care and 401(k) contributions and we’re only taking home $3000 a month. Could we really afford to carry a mortgage of $1200 a month? I did the math:
- $1200/mo. mortgage payment
- $140/mo. in student loans
- $259/mo. in car payments
- $300/mo. in transportation costs (this includes gas and insurance on our vehicles)
- $400/mo. for food
- $350/mo. for utilities and telecom expenses (cable, Internet, wireless)
- $250/mo. for my daughter’s preschool and dance classes
The grand total? $2899 a month in expenses. That only gives us $101 in discretionary income; hardly a safety net, especially amid today’s economic climate.
My Beef With Today’s DTI
I think lenders that allow potential homeowners to take out mortgage loans that would give them a debt-to-income ratio between 38 and 41 percent are being grossly negligent. Essentially, they’re setting borrowers up to fail – and fail miserably.
Since the banks’ limits are dangerously high, it’s up to us to protect ourselves. This is a case where we have truly become our own worst enemies. And if we, as borrowers, don’t hold ourselves and our finances accountable, we are doomed to repeat the real estate crisis that’s plagued this nation for the past half-decade.