So you want to buy a house? Chances are you don’t have the funds to buy that dream house outright with cash—not many people do. While it’s true that the percentage of all-cash home purchases is currently at an all-time high, that number still only makes up 30 percent, or less than one-third, of all home purchases.
If you make up the other 70 percent of home buyers, you’ll need some sort of loan to secure the house. And while private loans are possible, the vast majority of home buyers—nearly 62 percent—secure a mortgage in order to purchase their dwelling.
It sounds simple enough, but getting a mortgage is an intensive process. And, unless you look good to the lender on paper, you may not qualify for said mortgage.
What are some things that may affect your ability to get a mortgage? No credit history, poor credit history, or a non-salaried job are all reasons why you might get denied. But there’s another big one that you might not know about—it’s called debt-to-income ratio.
Debt-to-income ratio, also commonly referred to as DTI, is the percentage of your monthly gross income that goes toward paying off your debts. For example, if you pay an average of $1,000 per month in debts and make $10,000 per month, your debt-to-income ratio is 10 percent.
To a mortgage lender, this type of DTI looks pretty good. While the approved DTI varies from lender to lender, generally, they’re looking for a debt-to-income ratio of 36 percent or lower, with no more than 28 percent of that debt going towards servicing a mortgage or rent payment. Occasionally, lenders will approve a DTI of 43 percent or lower.
What’s the big deal, you might ask? Although you may think you can afford a mortgage, lenders want to be 100 percent sure you will be able to make your mortgage payments—and make them on time. They also know you will still need funds to cover existing debt payments, as well as other bills, like utilities, food, and even entertainment.
So what should you do if you find yourself in a position where your DTI is less than favorable? Don’t despair—though it may take some time, there are steps you can take to lower your debt-to-income ratio and get that house of your dreams. Here’s how:
Reduce credit card debt
Experts say you should only use credit cards for things you have the liquid cash to purchase. And there’s good reason for that. Though minimum payments are often low, it’s much more favorable to pay the balance in full. When you carry any type of balance, you incur interest, which can cause your debt to snowball. Do your best to pay off any credit card balances you may have.
Review all of your debts
Take a hard look at the full picture of your debts. Print out all of your statements and note the type of debt, as well as interest rates and interest deductibility. This way, you can make sure you aren’t missing any monthly payments. And, perhaps even more importantly, you can start to make a plan for tackling your debt. There are plenty of free tools to help. Check out Credit Karma’s Debt Repayment Calculator. It can help you get a sense of how long it will take to pay off your credit card debt.
Refrain from making big purchases
If you’re considering applying for a mortgage, hold off on other big purchases for the time being. That new car or appliance set you have your eye on may not seem like a huge expense in the grand scheme of things, but if you can’t pay cash for it, skip it. If you open a new account to finance a purchase like this, it will immediately increase your debt to income ratio—a red flag to lenders, especially if your DTI already straddles the line of acceptable or not.
Don’t forget to include other sources of income
Do you have a side hustle designing websites or writing marketing materials? Maybe you have a small photography business or a sizable social media following from which you earn affiliate revenue? No matter where the money comes from, make sure to include it in your loan application. Generally, lenders want you to prove two years of consistent income from non-W2 jobs in order to include it in the loan application, but it’s worth a shot. And, in some cases, even if the dollar amount is small, it can be exactly what you need to get over the hump of what the lender deems acceptable.
Check in with yourself
Sometimes these big, looming financial goals—like decreasing your debt-to-income ratio—can feel like lengthy, insurmountable tasks. But here’s a little psychological trick that can help keep you motivated: check in with yourself. Recalculate your debt-to-income ratio on a monthly basis to see if you’re making progress. When you see your DTI fall, it can help you stay motivated—the key to progress.