When someone is looking to qualify for a home loan, in addition to income and credit history, the borrower’s debt-to-income (DTI) ratio is going to be taken into consideration. This means that any FHA lender will analyze an applicants spending habits, totaling monthly recurring debts alongside earnings to calculate income to debt ratios. This process is part of risk assessment and helps ensure that a borrower doesn’t overcommit to a loan they simply cannot afford.
An approved FHA lender may not always accept the minimum borrower requirements set by FHA. There may be special conditions that overlay, adding on extra requirements…
So there there are basically two things to be mindful of. First, start with the basic debt requirements established by FHA and second, be mindful of any additional requirements that a lender may add on top of those bare minimum standards.
The Standard FHA Debt Guidelines
The basic DTI requirements and general FHA mortgage lending guidelines are established in HUD’s FHA 4000.1 Handbook. This serves as the foundation for what a mortgage company must follow when originating loans and funding a FHA loan. These guidelines help FHA approved lenders originate loans that are insured, reducing risk in cases where a borrower goes into default or a property goes to foreclosure. If you are dealing with a lender that sticks strictly to these guidelines and do not have additional requirements to qualify, then you’re dealing with a “no overlay” lender.
FHA Lender Overlay DTI Guidelines
Just because the FHA sets certain guidelines that define minimum borrower requirements it doesn’t mean a private lender has to play by those rules. As private companies, FHA approved lenders may decide that it is best for their businesses to add some additional borrower requirements to help them reduce risk.
In some cases, additional requirements may exist depending on low credit scores. For example, to get approved for a FHA loan, the minimum credit score requirement is just 580. For a borrower with a 580 FICO score, it still may be difficult to get approved with anything less than 620. Depending on the lender, some banks can accept more risk in their client portfolio whereas others may need you be at 640 or better. This is a scenario that a borrower who is working with a no lender overlay company will not have to worry about.
There is More Than One Debt Ratio
Whether the mortgage company is a no overlay lender or not, there are two debt ratios that may be considered. There is a front-end ratio and a back-end ratio.
A front-end ratio is basically a measure of housing expenses relative to earnings. This is calculated by taking your gross income and dividing it by your future mortgage payment. The mortgage amount includes principal, interest, tax, and insurance (PITI) and the FHA standard for this is currently set at 31%. Many lenders will hope to see a front-end ratio of 28% or less for most loans.
The back-end ratio is your more basic “debt-to-income” ratio and is calculated by dividing your gross income by the sum of your new PITI mortgage payment and your minimum monthly payments from liabilities such as credit card debt or child support. The standard FHA guideline for this is 43% and lenders really hope to see applicants that have a DTI of 38% or less.
What Expenses Go Into My DTI Ratio Calculation?
It may be a little unclear as to which of your expenses count as recurring or monthly debt. For example, many people may expect things like cell phone and internet bills, utilities, health and car insurance, and other basic items to factor into DTI. The truth is that many of your bills that do not show on your credit report will typically not be factored into your DTI ratio.
What your DTI will include is consideration for the minimum amounts you owe on each of the following account types except in cases where you are 9 months away from having a zero balance.
- Vehicle/Auto Loans
- Student Loans
- Personal Loans
- Credit Card Amounts
- Monthly Child Support
- Alimony Payments
- Any Tax Liens
As we mentioned, many lenders will hope to see a borrower that has a DTI that is less than 38% though FHA home loan guidelines will allow your ratio to go up to 41%. Of course, you do need to be mindful of any lender overlays!
If in case your DTI exceeds this, which is often the case for millennial home buyers with high student loan bills or those with large credit card debt, there may be an opportunity to have considerations included in your application.