2014 Debt-to-Income Ratio Update: FHA, Conventional Mortgages, and QM
There are new rules for mortgage debt-to-income ratios in 2014, as well as some old standards that will carry over from 2013.
Mortgage lenders use the DTI ratio, as it’s known, to measure a borrower’s ability to repay the loan obligation. Simply put, if you carry too much debt in relation to your monthly earnings, you might not qualify for a home loan. Here’s what borrowers need to know about this key requirement in 2014.
Definition: The debt-to-income (DTI) ratio shows the percentage of a person’s income being used to cover his or her recurring debts. It is calculated at the monthly level using gross, or pre-tax, income. For instance, a borrower with a DTI ratio of 25% is using one-fourth of his/her income to cover recurring debts (car payments, credit cards, housing, etc.).
When it comes to mortgage approval guidelines, there are two types of debt-to-income ratios.
- The front-end or “housing” ratio only looks at housing-related debts, such as monthly mortgage payments and property taxes.
- The back-end or total DTI ratio takes all recurring monthly debts into consideration, including the mortgage.
Most of the 2014 DTI guidelines mentioned in this article relate to the back-end debt ratio, in particular. The graphic below shows how to calculate this number.
General Rule for Conventional Mortgages: 28/36
A conventional mortgage loan is one that is not insured by the government. This distinguishes it from the FHA program mentioned in the next section. In 2014, the general rule for debt-to-income ratios on conventional mortgages will be 28/36. This has been the norm for several years now. This means the borrower’s monthly housing debt should use no more than 28% of gross monthly income, while the back-end DTI should not exceed 36%.
You can multiply your gross monthly income by .28 and .36 (the decimal form of the DTI percentages) to get an idea where you stand.
Examples of the 28/36 standard:
- Monthly income of $4,800 x .28 = $1,344 maximum allowable housing-related debt (front ratio)
- Monthly income of $4,800 x .36 = $1,728 maximum allowable overall debt (back ratio)
The above limits are not set in stone. Some lenders will make exceptions to these general rules for borrowers who have compensating strengths in other areas (such as a larger down payment). We spoke to one mortgage broker who said she often sees borrowers with back-end DTI ratios as high as 45% get approved for conventional financing.
Bottom line: The numbers listed above represent a rule of thumb that may apply to debt-to-income ratios in 2014. It varies from one mortgage lender to the next. Borrowers should inquire about DTI limits up front, when first approaching a lender.
FHA Debt-to-Income Ratio for 2014
HUD Handbook 4155.1 explains the FHA debt-to-income ratio limits for 2014. According to Chapter 4, Section F of the handbook: “Qualifying ratios are used to determine if the borrower can reasonably be expected to meet the expenses involved in home ownership, and provide for his/her family.”
To make this determination, mortgage lenders must calculate the two ratios mentioned above. HUD has specific, and somewhat complicated, names for them:
- Mortgage Payment Expense to Effective Income ratio (a.k.a., front-end DTI)
- Total Fixed Payment to Effective Income ratio (a.k.a., back-end DTI)
According to the official HUD Handbook, borrowers are limited to having debt ratios of 31% on the front end, and 43% on the back end.
On the surface, this indicates that borrowers with DTI numbers above these stated limits could have a harder time qualifying for FHA loans. But that’s not always the case. There are exceptions to the official 2014 FHA debt-to-income caps. HUD allows for higher ratios in cases where the lender can identify and document “significant compensating factors.” A list of these factors can be found in Chapter 4, Section F-3 of the aforementioned handbook.
We posed this question to a number of lenders, for additional clarification. Some lenders told us that borrowers can have a back-end DTI as high as 50%, or even higher, with compensating factors such as a strong employment history or significant cash reserves in the bank.
At the beginning of 2013, HUD issued a new rule that will affect FHA debt ratios in 2014. In short, any borrower with a DTI above 43% and a credit score below 620 must undergo additional underwriting scrutiny.
Forthcoming ‘QM’ Rule Sets a DTI Limit at 43%
In 2014, a new set of lending rules will reshape the mortgage industry. The Qualified Mortgage rule, or QM, was finalized earlier this year and takes effect on January 10, 2014. There are various components to the QM rule. Among other things, it prohibits balloon payments and negative-amortization loans, and limits certain points and fees to 3%. It also caps debt-to-income ratios at 43%, starting in 2014.
According to some analysts, the DTI limit could be the most impactful element of the new rule. Sam Khater, an economist with housing data company CoreLogic, told U.S. News:
“The largest constraint is the 43 percent threshold. It will hit more refinances than purchases because a lot of them use a high debt-to-income ratio. It will also hurt home borrowers in distressed environments.”
Disclaimer: This article explains mortgage DTI ratio limits for 2014, including FHA and conventional home loans. For the most part, these are general rules with plenty of exceptions. Individual lenders often establish their own debt-to-income guidelines. There is no industry-wide rule or standard. It varies. This information has been provided for reference purposes only and does not constitute financial advice.