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Before we get into the changes Fannie Mae recently made to its debt-to-income ratio limit, let’s review what a debt-to-income ratio is.
Your debt-to-income ratio (or DTI ratio, for short) weighs how much you owe each month against how much you earn. It’s generally calculated by adding up your monthly bills and dividing the total by your gross monthly income – more on that later.
Though it’s not used to calculate your credit scores, your DTI ratio can play a key role when you apply for a mortgage. Why? Because it helps mortgage lenders evaluate how much additional debt you can handle.
Carrying too much debt is one of the main roadblocks for many first-time homebuyers who apply for a mortgage.
Lenders generally view such borrowers as being higher-risk — even if they make good money and have strong credit. However, that perception may be starting to shift.
Fannie Mae, the leading provider of mortgage financing in the U.S., is relaxing its debt-to-income ratio requirements to give more potential borrowers access to credit.
The increase, which took effect July 29, allows borrowers to have a DTI ratio limit of 50 percent, up from 45 percent.
If you have a high debt-to-income ratio but great credit and a stable income, Fannie Mae’s higher DTI ratio limit might help you get approved for a mortgage. But for homebuyers who don’t fit this bill, the new limit is unlikely to help much.
Let’s take a closer look at how Fannie Mae’s limit increase impacts your loan-approval chances.
How does the DTI ratio work?
Raising the DTI ratio limit is one of many new enhancements to Fannie Mae’s Desktop Underwriter®, the agency’s default risk-assessment tool. But how does it factor into your application?
When you apply for a mortgage, lenders need to assess your ability to repay the hundreds of thousands of dollars they’re loaning you. Calculating your DTI ratio is an important way to do that.
First, lenders add up your monthly debt payments — like credit card payments, car payments and student loans — and your new monthly mortgage payment.
The sum is then divided by your monthly gross income (that’s how much you make before taxes or deductions) to get your DTI ratio as a percentage.
Note that expenses such as groceries, utilities and gas generally don’t factor into your DTI ratio, so you’ll want to leave those out when making your calculations.
Let’s crunch some hypothetical numbers to see how Fannie Mae’s new DTI ratio limit may affect you. In the example below, we assume your monthly gross income is $5,000 and your total monthly debt is $2,250:
|Monthly gross income: $5,000|
Estimated new mortgage payment: $1,300
Credit card minimum payment: $400
Car payment: $300
Student loan: $250
Total monthly debt: $2,250
DTI ratio: 45 percent
Under the new limit increase, you could carry an additional $250 in monthly debt (a total of $2,500) for a DTI ratio of 50 percent, and qualify for a Fannie Mae loan.
Who benefits from the new DTI ratio limit?
Borrowers who have strong credit scores and a steady income but live in expensive housing markets are likely to benefit the most from the DTI change, says Michael Fratantoni, chief economist with the Mortgage Bankers Association.
That’s because they otherwise wouldn’t qualify for a conventional loan, and they’d have to take out a jumbo loan, he adds.
Jumbo loans are also called “non-conforming loans” because the loan amount exceeds the limits established by Fannie Mae and Freddie Mac.
While most properties in the U.S. have a loan limit of $424,100, some in higher-cost areas have a higher limit of $636,150, according to the Federal Housing Finance Agency.
That said, the average borrower won’t suddenly have more access to mortgage credit because of a higher DTI ratio limit, Fratantoni says.
After all, he notes, lenders may also look at your credit payment history, FICO score, income and credit utilization to determine if you can repay your loan.
Fannie Mae also has two major caveats to the new limit increase:
- Borrowers with a DTI ratio between 45 percent and 50 percent must also have at least 12 months’ worth of cash reserves.
- The loan amount must be less than or equal to 80 percent of the property’s value.
The reality is that many first-time homebuyers simply don’t meet both of those criteria, says David Hosterman, branch manager of Castle and Cooke Mortgage in Greenwood Village, Colorado.
Regardless of whether you’ll use Fannie Mae’s extra wiggle room, the first step is to meet with a lender early on — at least six months before you buy, Hosterman recommends.
Meeting with a lender and knowing your FICO score early on gives you time to iron out any errors and potentially see meaningful improvement in your credit, he adds.
What are the mortgage alternatives?
Fannie Mae loans are just one of many options out there for first-time homebuyers who need an extra leg up, Fratantoni points out.
“[The Federal Housing Administration] already serves this share of the market,” Fratantoni says of homebuyers who have high DTI ratios. “From a pricing perspective, most of the borrowers in this space are still going to be better off with an FHA loan.”
It’s more than likely that the DTI ratio limit isn’t the main culprit holding these borrowers back, Fratantoni explains.
FHA loans typically require borrowers to put at least 3.5 percent of the loan amount down to qualify, and you may also need a FICO score of at least 580 (though lenders may have different requirements).
On the other hand, conventional loans require a 620 FICO score for loans backed by Fannie Mae — even though you can now pay as little as 3 percent for a down payment.
However, FHA borrowers must pay an upfront mortgage insurance premium and monthly mortgage insurance payments for the life of the loan. And that can add up over time.
While Fannie Mae’s move is a good-faith effort to give more homebuyers a shot at homeownership, it’s unlikely to have much of an impact on many first-time homebuyers.
If homeownership is on the horizon soon, be mindful of your credit score and history, and work on paying down your debt more aggressively. When it comes time to buy, you may have a stronger chance of qualifying for a loan with competitive interest rates and better terms.
After all, you don’t want buyer’s remorse over the largest financial purchase of your life.