When taking out any loan, most especially a mortgage loan, lenders will want to determine your ability to make on-time monthly payments. To do this, they will look at your Debt-to-Income (DTI) ratio which is a calculation that takes into account your overall monthly debt payments and your gross income. The lower your DTI is, the lower your debt is, meaning lenders will see you as a capable borrower.
Before applying for a loan, take into consideration your DTI ratio to determine if you are ready to take one on. Don’t know how? No worries, let’s learn how to calculate your DTI ratio and know the DTI ratio requirements for FHA loans.
FHA Loans
One of the ways many first-time homebuyers and low to middle-income earners buy a home is through an FHA loan.
With this loan, the requirements to qualify are more flexible compared to conventional loans. For instance, the minimum credit and down payment requirements are lower. Additionally, the FHA is also more forgiving for those with negative financial history and those with higher DTIs, given certain conditions.
But remember that the FHA doesn’t provide loans but insures FHA-approved lenders. The final requirements and guidelines may differ from one lender to another. Therefore, it is important to find the right lender for your needs.
Additionally, to increase your chances of getting approved for an FHA loan, talk to your loan officer and get pre-approved as soon as possible. Through this, your financial standing is clarified and you will also get an idea of how much you can qualify for. This will help kickstart your search for the right home.
How to Calculate Debt to Income Ratio for FHA Loan
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The formula to calculate one’s DTI ratio is easy to do and is consistent throughout all types of loans – including the FHA loan.
Step 1:
Add up all your monthly debt payments. These may include:
- Monthly credit card payments
- Monthly car payments
- Monthly student loan payments
- Monthly child support payments
- Other debts
Note that expenses such as grocery shopping, utilities, and gas are not included. Tax is also not included in the equation.
Step 2:
Divide the total by your gross monthly income. For example, let’s say Roy has a total monthly debt payment of $2,000. Meanwhile, his gross monthly income is $5,000. If we divide $2,000 by $5,000, we’ll get 0.4.
Step 3:
Since we are looking for the percentage of your gross monthly income that goes towards debt payments, we’ll multiply the answer by 100 and the product is the final result. Going back to our example, if we multiply 0.4 by 100, we’ll get 40%. Thus, Roy has a DTI ratio of 40%.
DTI Requirements for FHA Loan
Now that you know how to calculate your DTI ratio, it’s time to determine what this number means.
According to the FHA official site, “The FHA allows you to use 31% of your income towards housing costs and 43% towards housing expenses and other long-term debt.”
The ratio percentage of 43% is standard across all FHA loans, including the FHA 203(k) and refinancing as well.
Ensure that before you apply, you have a good estimation of your DTI and you know you have a high chance of getting approved.
What are the Qualifying Ratios on FHA Loans?
With FHA ratios, there is the front-end-DTI and the back-end DTI. You may be wondering what’s the difference and what are its qualifying ratios.
What is the Front-End Ratio for an FHA Loan?
Your front-end ratio is just your mortgage payments divided by your gross income.
For FHA loans, your front-end DTI should be 31% or less.
What is the Back-End Ratio for an FHA Loan?
Your back-end ratio is what we looked for earlier, it is all your monthly debt payments divided by your gross income. For FHA loans, that should equal 43% or less.
What is the Maximum DTI for FHA Loans?
In general, the FHA requires a DTI of at most 43%, but a higher ratio of up to 56.9% may be acceptable if there are significant compensating factors.
According to HUD 4155.1 Chapter 4, Section F, these compensating factors may include:
- High down payment – If the borrower makes a large down payment of 10% or higher.
- Accumulated savings – The borrower has demonstrated an ability to accumulate savings and a conservative attitude toward using credit.
- Positive Credit History – A borrower’s previous credit history shows that they can devote a greater portion of income to housing expenses.
- Compensation or Income Not Reflected in Effective Income – The borrower receives documented compensation or income that is not reflected in effective income but directly affects their ability to pay the mortgage. This type of income includes food stamps and similar public benefits.
- Substantial Cash Reserves – The borrower has substantial documented cash reserves (at least three months’ worth) after closing. The lender must judge if the substantial cash reserve asset is liquid or readily convertible to cash, and can be done so without retirement or job termination.Reserves from retirement accounts and gifts as described above may be considered cash reserves when scoring the mortgage application through TOTAL.
- Substantial Non-Taxable Income – The borrower has substantial non-taxable income.
- Potential for Increased Earnings – The borrower has a potential for increased earnings, as indicated by job training or education in his/her profession.
- Primary Wage-Earner – The home is being purchased because the primary wage-earner is relocating, and the secondary wage-earner has an established employment history, is expected to return to work, and has reasonable prospects for securing employment in a similar occupation in the new area.
FHA DTI Requirements are Flexible
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The standard guideline for FHA DTI ratios is nothing over 43%. This number represents the amount of debt you’re paying in relation to your gross monthly income. However, FHA loans are flexible and may accept a higher DTI ratio of up to 56.9% if you have significant compensating factors. The most common is a high down payment, a lot of accumulated savings, a high credit score, etc.
Buying a house takes time. Knowing your DTI is crucial as it helps you gauge your financial capability and likelihood of getting accepted to a loan. If you have any more questions about finding your DTI ratio, don’t hesitate to contact us.
Frequently Asked Questions
Does FHA use gross or net income?
When it comes to calculating your DTI ratio, gross income is used.
How can I reduce my debt-to-income ratio?
There are two ways to reduce one’s DTI ratio – lessening one’s debts or increasing one’s salary. A combination of both would work too.
What should my DTI be before buying a house?
The lower your DTI ratio, the better. Although the DTI ratio limit for FHA loans is 43%, a 36% or lower DTI ratio is ideal for all types of loans.
