New mortgage rules taking effect in 2014 will set the bar for allowable debt ratios. These rules will apply to FHA and conventional loans alike, though in different ways and at different times. In short, many borrowers with debt-to-income ratios above 43% will be shut out of the mortgage market. Here’s what you need to know.
Definition: The debt-to-income ratio (DTI) compares the amount of money a person earns to the amount he or she spends on recurring debts. For example, if I spend half of my monthly income on my various debts, I have a DTI ratio of 50%. My combined debts eat up half of my income.
These ratios have always been an important part of the mortgage qualification process. For years, lenders have had their own internal guidelines and cutoff points for debt ratios. But it’s about to become standardized across the industry.
FHA Caps Debt Ratio at 43% for Certain Borrowers
FHA loans are incredibly popular these days. The FHA’s market share peaked at nearly 40% at the end of 2009. Back then, credit was tight for conventional mortgage loans. So many home buyers had little choice but to use the FHA program, with its easier qualification criteria.
But a new rule announced by HUD recently could make FHA loans harder to obtain in 2013, at least for some borrowers. The new rule has to do with credit scores and debt-to-income ratios. In short, borrowers with scores below 620 will have their debt ratios capped at 43%. Ratios above that level could result in disqualification.
Here is an excerpt from a recent letter by Carol Galante, commissioner of the Federal Housing Administration:
“FHA … will require borrowers with scores below 620 to have a maximum debt-to-income ratio no greater than 43% in order for their loan applications to be approved through FHA’s TOTAL Scorecard … If a borrower’s DTI exceeds 43 percent, lenders will be required to manually underwrite the loan.”
Translation: If a mortgage applicant has a credit score below 620, and a DTI ratio above 43%, it will send up a red flag in the FHA’s automated underwriting system (TOTAL Scorecard). At that time, the lender must manually review the applicant’s file to see if there are any offsetting factors. Borrowers who fall into this range may have a hard time qualifying for FHA loans in 2013.
Qualified Mortgage (QM) Rule Also Includes 43% Cap
On January 10, 2013, the Consumer Financial Protection Bureau (CFPB) announced a new set of mortgage rules. Collectively, these rules are known as the qualified mortgage, or QM. They are scheduled to take effect a year from now. In short, a qualified mortgage is a home loan that meets certain criteria designed to minimize risk. The debt-to-income ratio is one of those criteria.
According to CFPB, QM loans “generally will be provided to people who have debt-to-income ratios less than or equal to 43%. This cap on debt ensures consumers are only getting what they can likely afford.”
Again, the QM rules won’t take affect until 2014. And even then, there will be a transition period where borrowers with DTI ratios above 43% may still be approved. But the writing is on the wall. The federal government is drawing a line at 43%, and this will eventually trickle down to the primary mortgage market where loans are made.
Borrowers are Not Powerless
Here’s the bottom line to all of this. Borrowers who are planning to apply for a mortgage in 2013 need to review their debt-to-income ratios. The FHA rule for DTI ratios is already taking affect. The qualified mortgage rule (for conventional loans) doesn’t take effect until next year. But it’s a safe bet that most lenders are already adjusting their procedures to match the 43% cap. This is typically how the industry changes — in advance of regulatory deadlines.
What does it mean to you, as a borrower? It means you need to see where you stand right now, before applying for a loan. The sooner the better. Use a debt-to-income calculator to get started. If your total / back-end DTI ratio is above 43%, you’re in the ‘red zone.’
If your back-end ratio is much higher than 43%, you should consider lowering it. There are two ways to bring that number down. You can either increase your income or reduce your debts. For most people, the second option is more realistic. (If it were so easy to elevate your income, you would have done it by now.)
Make a conscientious effort to pay down your debts, starting with those high-interest credit cards. You’ll sleep better at night, and you’ll have an easier time getting a mortgage loan, when the time comes.