Debt-to-income ratio can sink mortgage application

REAL ESTATE TOPICS

Home buyers need to know that debt-to-income ratios are the most direct indication to a bank about whether buyers can afford to repay a mortgage. (Craig Warga / Bloomberg)

By KENNETH R. HARNEY

WASHINGTON — For many home buyers, qualifying for a mortgage not only is a tough challenge but one that ends unhappily: They get rejected.

The reasons for the turndowns typically involve multiple factors, including below-par credit scores, inadequate documented income to support the monthly payments, and little savings in the bank.

But a new survey by credit-score giant FICO offers buyers a rare peek inside the heads of credit-risk managers at financial institutions across the country and in Canada. Researchers asked a representative sample of them what single factor in an application makes them most hesitant to fund a loan request — in other words, what's most likely to prompt them to say no.

The results provide practical insights to anyone who is thinking about applying for a mortgage. Tops on the list? Surprise, it's not your credit scores. It's not how much you've got for a down payment or what's in the bank. It's your "DTIs" — your debt-to-income ratios. Nearly 60% of risk managers in the FICO study rated excessive DTIs their No. 1 concern factor — five times the percentage who picked the next biggest turnoff

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Yet many new buyers have only a rough idea in advance of an application — even for a pre-approval letter — about their own DTIs, how lenders view them, and what sort of limits they're likely to encounter.

Since they are so important to a successful application, here's a quick overview on what goes into DTIs and why they are such a big red flag. Debt-to-income ratios for home loans are the most direct indication to a bank about whether you are going to be able to afford to repay the money you want to borrow.

Debt ratios for home loans have two components.

The first measures your gross income from all sources before taxes against your proposed monthly housing expenses, including the principal, interest, taxes and insurance that you'd be paying if the lender granted the mortgage you sought.

As a general target, lenders like to see your housing expense ratio come in at no higher than 28% of gross monthly income, though 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%.

The second DTI component — the so-called back-end ratio — measures your income against all your recurring monthly debts. These include housing expenses, credit cards, student loans, personal loan payments and others. 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%. Even at FHA, which tends to be more lenient on credit matters than Fannie or Freddie, the average back-end ratio for buyers was 41%. The average for denied applications was 47%.

A good place to learn more about DTIs and to compute your own is Fannie Mae's consumer-friendly "know your options" site (www.knowyouroptions.com), which includes calculators and other helpful tools.

The new FICO survey found that the second leading cause of concern for loan officers is "multiple recent credit applications." Lenders spot these on your credit reports and take them as signals that you are seeking to add on even more debt, which could affect your ability to repay the mortgage money you're asking them to give you.

In third place as an instant turnoff: your credit scores. Most lenders want to see FICO scores well above 700 — Fannie and Freddie averages were in the 755 range in May; FHA average approved scores were a more generous 684.

Bottom line here: If you want to be successful in your mortgage application, be aware of these key turnoff points for lenders and take steps to avoid the tripwires. Most important: Postpone your purchase until your DTI ratios tell you that yes, you can afford the house you want and lenders won't reject you out of hand.