Debt to Income Ratios Explained
Why You Can’t Buy a New Car - Yet!
All over Silicon Valley, people are living out their American dream and buying their own home. And all over the Silicon Valley, some people are living a nightmare because they bought a new car to put into that new home…before their closing.
So, what’s the big deal? The big deal is a little thing called “debt-to-income ratio.” Understanding this common real estate term can save you plenty of headaches when buying a home.
What It's All About
This fancy term describes a lender’s simple way of illustrating what percentage of your income is available for a mortgage payment after your other major monthly debt is paid. This “other” debt might include student loans, car loans or even that Sears credit card that mysteriously keeps getting used.
In other words, this ratio tells a lender how much a home buyer can reasonably borrow and pay back. This ratio is determined at the beginning of your home buying process during pre-qualification.
Conventional loans largely have a qualifying ratio of 28/36, and these two numbers represent two different facets of your debt.
The first number represents the maximum portion of your monthly gross income – that is, before taxes – a lender will allow for essential housing expenses, including loan payments, property taxes, home owners’ association fees, private mortgage insurance and hazard insurance.
The second number represents the maximum portion of your monthly gross income that the lender allows for the debts mentioned above plus your recurring debt including auto or student loans, credit card payments and other such debts that may not be paid off quickly.
Let's Run The Numbers
For this example, let’s say a husband and wife earn $81,000 a year. Here’s how a lender might calculate their debt-to-income ratio for a conventional loan with a qualifying ratio of 28/36:
Annual Gross Income = $81,000
Monthly Income = $6,750
$6,750 x 28% = $1890 allowed for housing expense or PITI (principal, interest, taxes & insurance)
$6,750 x 36% = $2,430 allowed for PITI plus recurring debt
Closing First, Car Last
So, if this family’s debt plus housing expenses remains at or below $2,430, then they can be on their way to owning a home.
But if their debt suddenly exceeds this number they may destroy their chances of getting a home loan. So, if this couple buys that Nissan Altima they’ve been eyeing since the end of football season, they can say goodbye to their dream home.
And it happens all the time. Just days before meeting at the closing table, clients purchase everything from cars to refrigerators, from bedroom sets to summer wardrobes, and they forget they’re in the process of buying a home. Dreams are literally lost at the closing table.
Realtors have a saying, “If you buy a car while trying to buy a home, you just may find yourself living in that car.”
When entering into the home buying process it’s important to set priorities, get a Realtor, make a plan and stick to it!
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