Mortgage Loans: Is Too Much Debt the New Deal-Breaker?

In the years following the housing crisis, credit scores emerged as a crucial part of the mortgage approval process. Used as a measurement of risk, the credit score has the power to make or break your chances of getting a mortgage loan, all by itself. In 2013, most lenders are looking for a score of at least 620, when qualifying mortgage applicants.

Most consumers are familiar with the concept of credit scores. We are bombarded by TV commercials that stress the importance of good credit. We encounter the dreaded ‘credit check’ when we buy cars. It has become a rite of passage in the world of finance.

But there’s another, less familiar aspect of the mortgage-approval process. It is the debt-to-income ratio, or DTI. And it’s emerging to become the latest deal-breaker for many would-be home buyers.

Debt-to-Income Ratio Defined

The debt-to-income (DTI) ratio is a comparison between a borrower’s monthly recurring debts and gross monthly income. When it comes to mortgage loans, there are two types of DTI ratios — one that only includes housing debt, and one that includes all recurring debts. The total or ‘back-end’ debt ratio is the more important number, where mortgage loans are concerned.

Example: John and Jane are applying for a mortgage loan. The payments on their new loan will come out to $1,500 per month. All of their other debts (credit cards, student loans, car payment, etc.) add put to $500 per month. So their total debt equals $2,000. Their combined gross monthly income is $8,000 per month.

To calculate the couple’s total, or back-end, debt-to-income ratio, we would simply divide the debt amount by the income amount: 2,000 ÷ 8,000 = 0.25, or 25%. That’s actually very good, so it shouldn’t raise any red flags when applying for a mortgage loan.

So why have debt ratios become such a big deal in the mortgage world? Two reasons:

  • Many Americans racked up additional debt during the recession, especially in the credit card department.
  • Lenders are putting more emphasis on debt ratios these days, as a result of financial losses and new government rules (see below).

New Government Rules to Cap DTI at 43%

Earlier this year, the Consumer Financial Protection Bureau (CFPB) announced a new set of mortgage rules that will take effect in January 2014. Among other things, these rules created the concept of a Qualified Mortgage, or QM. A QM loan is one that meets certain risk-reducing criteria established by CFPB. All of this is required by the Dodd-Frank Act, by the way.

There are hundreds of pages of supporting documents relating to the QM rule. So let’s zero in on what it says about debt-to-income ratios, in particular:

“QMs generally will be provided to consumers who have a total debt-to-income ratio (rather than a more limited housing debt-to-income ratio) less than or equal to 43 percent.”

This statement comes from a “Small Entity Compliance Guide” published by CFPB earlier this month.

Borrowers with DTI ratios above 43% squeezed out of mortgage market?

A Bit of Good News: Household Debt is Declining

Fortunately, many Americans appear to be digging their way out from under the mountains of debt piled up during the recession. This week, the Federal Reserve released data that show household debt is falling in the U.S.

The household debt-service ratio, which compares consumer debt burdens to disposable personal income, has fallen to 10.38 percent. That’s the lowest level since 1980, when the government began tracking this particular metric. Mortgage debt payments dropped to 8.67 percent of disposable income in the fourth quarter, the lowest in nearly 13 years.

Despite these improvement, debt-to-income ratios will still put mortgage loans out of reach for many borrowers.