Of the 3 major criteria needed to qualify for a mortgage to buy a home, Credit, Capacity, Collateral, today, we will focus on Capacity. In other words, we’ll talk about how income is calculated, your DTI (debt to income ratio) and how that ratio is used to underwrite your mortgage.
How is my income calculated to qualify for a mortgage?
For most of us, we obtain our income from our job. Most lenders require a 2 year job history in the same line of work. However in some cases, if you have just graduated from an educational institution and have a job in your field of study, the 2 year requirement can be waived. What is used is your annual salary divided by 12 or your hourly wage x 2080(52 weeks x 40 hours per week) divided by 12.
For example, John in Overland Park, Kansas, wants to buy a home. He has worked for 3 years in manufacturing and makes $25/hour. John’s income for qualifying purposes is $4,333($25x 2080/12).
How is my debt to income ratio calculated for my mortgage?
PITI(MI)/INCOME = “Front End Ratio”
(PITI(MI) + other debts)/INCOME = “Back End Ratio”
Once we’ve established income for a borrower and input that number into the denominator(bottom number), we compile the list of debts listed on the borrower’s credit report and put that into the numerator(top number)…..Remember fractions class?
Back to our example: John, who has income of $4,333/month has a credit report with monthly payments of $350 for a car and $50 for a credit card and wants to buy a home for $150,000 with a principle and interest payment of 716/month(PI), taxes and insurance of $225/month(TI) for a PITI of 941. The Debt to Income Ratios (DTI) will come together as follows:
Front End Ratio: PITI/INCOME 941/4333 = 21%
Back End Ratio is(PITI+other debts)/INCOME (941+400)/4333 = 31%
What do the DTI ratios mean?
These ratios are compared to a standard when used to qualify a borrower for a mortgage. While those standard vary from product to product and based overall strength of compensating factors such as credit score, and assets, a good rule of thumb is no more that 30% of your income should be for your housing(Front End) and no more that 40% when including all other debts(Back End). So in our example, John would qualify on DTI for his mortgage application.