Caution: Your Debt-to-Income Ratio Can Make or Break Your Investing Career
Right now, conventional lending rates in the U.S. are at historic lows.
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At the same time, some investors and new home buyers are finding it harder than ever to qualify for a loan for many reasons, including failing the underwriter's debt-to-income (DTI) criteria, insufficient income, and insufficient credit or credit history.
DTI is a lending qualifying criteria calculated as the percentage of total debt divided by total income. Conventional lenders use DTI as a measure of your ability to pay the debt service on the property. While different lenders have different DTI underwriting parameters, in June 2020 the max DTI for a Fannie Mae loan is 45% with a great credit score and proper reserves. (There are a couple of exceptions to this rule.) It’s worthwhile to note that the DTI underwriting parameters change over time, so be sure to work with your lender on what the parameters are at the time you apply.
While the formula to calculate DTI looks straightforward, let’s dive deeper into what actually makes up the numerator and denominator of the equation.
The lender will review all of your consumer and current property debt noted on your credit report. They will calculate your required payments on your consumer debt. This is generally noted on your credit report as well. After that, the lender will calculate the required payments (operational expenses) on your properties, which include principal, interest, taxes, insurance, and if applicable, homeowner’s association dues.
Pro Tip: As you scale your rental portfolio, make sure all properties have a debt service coverage of 1.25+ to avoid adding any investment debt to your personal balance sheet.
The lender will then calculate all qualifying income documented on your tax return for the past two years. For most people, their main source of income is W-2 income from a job. If you have additional investments, rentals, or self-employment income, you may be able to include it as well. (Make sure to talk to your lender to see if this income qualifies.)
Then the lender will take your total debt divided by your total income and multiply that figure by 100 to come up with a DTI percentage. (Here is a calculator to help you do a high-level calculation on your own.) If this DTI percentage falls within the lender’s underwriting criteria, you’ll be approved! If this DTI percentage does not fall within the lender’s underwriting criteria, you will most likely receive an “ineligible” recommendation.
How To Fix a High DTI Ratio
If you have been denied a loan for high DTI, or if you just went through the calculations above and realized your DTI is out of whack, hope is not lost. Follow the steps below to rehab your DTI.
Review Your Credit Report
There are things you can do to increase your credit score, thus helping to improve your DTI. You can open up another credit card account, pay all your bills on time, increase your credit limits, and more. For a thorough guide, check out this handy list 0f 12 simple steps to follow.
Decrease Your Debt Expenses
Pay off consumer debt/credit card debt noted on your credit report. For the purposes of DTI rehab, you should think about tackling the highest debt payment first.
You should also pay off any high interest/high payment loans on cars, trailers, RV, etc. Also consider selling these liabilities to ditch the debt payment, and maybe recoup some pocket change to add to your next down payment. Again, for the purposes of DTI rehab, think about tackling the higher debt payment first.
Increase Your Income
Schedule a meeting with your boss and ask what you need to do to get that promotion and/or raise. Take extensive notes—and then do it! Think about switching to a higher paying job (potentially with a competitor) or higher-paying field. Add in a side hustle or two and claim the income on your tax return.
And, of course, if you are super serious about building wealth, do all of the above!
Pulling It All Together
While the DTI ratio can seem like a daunting lender criterion to meet for a first-time investor or home buyer, this is one of the more straightforward underwriting criteria that you can personally impact. Once you get your debt-to-income in a good place, protect it, as this could be the very key to you building wealth through real estate.
What do you do to keep your debt-to-income ratio in a good place?
Share with a comment below!