One of the first tips I give people when they tell me they plan to buy a house next year is to focus on their Debt-to-Income ratio.
Most clients who buy homes get a mortgage, and find out quickly that their finances are about to get scrutinized. Even though ads for rocket-easy mortgages make it appear simple, they will still want you to provide your financial documents.
Essentially the lender will review your credit reports and FICO Score, will look at your recent pay stubs, look at your savings, and will look at your financial history primarily looking at recent tax returns.
My clients always want to know how much they will be allowed to borrow because, especially here in Vienna, home prices are high compared to most of the United States. Mortgage folks always get down to what they feel is THE important ratio, and working on your numbers today will help you improve your Debt-to-Income Ratio next year.
To calculate that top number, mortgage people use a simple formula:
monthly debt ÷ monthly income = Debt-to-Income Ratio
- Conventional Financing Debt-to-Income Cap: 45%
- FHA Financing Debt-to-Income Cap: 55%
So, knowing about this ratio is a great way to start working on your financial position today, and that will help you next year (or in six months).
And a critical thing for you to know is exactly which tasks you should be working on today.
Credit Cards: Don’t get any new credit cards but manage the ones you already have because mortgage people are looking at your long term history and a “seasoned” credit card showing on-time payments is good. Try and make sure the balance is below 30% of your credit limit.
Don’t freak out if you carry a balance.
If you have a VISA card with a low balance but a $22,000 credit line, then keep that card and do not cancel it.
Remember, they want to see how you responsibly pay and manage your credit cards. The mortgage folks will be looking at your Minimum Monthly Payment to use in their calculation.
Student Loans: Make sure that you pay these on time, and understand that the mortgage people look at student loans differently than a credit card. If your interest rates are high, maybe looking at lowering those rates is an option you haven’t considered because of your work schedule. One option is SoFI which has helped clients refinance (they don’t pay me for this link).
The mortgage folks will be looking at your monthly payment to use when calculating your ratio
Car Loans: Don’t buy a new car right now!
But since most of us have car loans, make sure that you pay on time. Mortgage people love to see that you have managed this type of consumer loan well and will, if you are within the last year of your car loan, possibly consider it paid.
Again, they are looking at your monthly payment.
FICO Scores: Mortgage lenders get a “tri-merge” credit report when you apply for a mortgage. So, you should take a look at your reports from the three major credit reporting agencies today to make sure there aren’t any errors.
Errors on credit reports can usually be fixed, but they may take a month or two to show up on your report. Starting today will give you a jump on improving the FICO Score your mortgage underwriter will see next year.
The mortgage folks will be looking at the minimum monthly payment amount reported on your credit reports when calculating your Debt-to-Income Ratio.
Improving your Debt-to-Income Ratio may take 6 months
Your new lower balances may not show up right away, and the ratio may not change significantly for six months. Know this is a worthy effort.
you will want to also focus on your savings account for your down payment.
Spending your time with a clear focus on improving what your future mortgage lender will see is worth it. The effort may also help you clarify other aspects of your life, but putting your finances in control is something most of us (Americans) need to work on too.