You may feel like your finances are your business, something you’d prefer to keep on the low. But when you decide to buy a home, financial privacy pretty much goes out the window. Before a lender will give you a loan, he or she needs to have a clear picture of your financial situation: what's coming in, what's going out and what you've got socked away.
Why the privacy invasion? Because lenders want to be sure you're not spending more than a certain percentage of your income on your housing. Like your parents, they don't want you to get in over your head. Remember, a financial institution’s entire enterprise rests on its ability to keep money safe. If lenders make a lot of loans that don't get paid back, they have a hot mess on their hands (search "housing crisis of 2008" or watch “The Big Short”).
To decide on the size of your loan, a lender will determine your debt-to-income ratio (DTI). For a conventional loan, lenders look for a DTI ratio no higher than 45 percent, says Claude L'Heureux, senior vice president of residential lending at Illinois-based Community Bank of Oak Park River Forest.
Think back to middle school for a moment: A ratio, like a fraction, can be expressed as a percent. For example, 3:4 is the same as 3/4 is the same as 75 percent. To determine your DTI ratio, a lender creates a ratio using two figures: your expenses and your income. There’s not one but two of these babies. Welcome to the world of front-end and back-end ratios.
Imagine a fraction where the top number is your monthly cost for the home you hope to buy. This figure will include principal, interest, property taxes and insurance (this is what lenders mean when they say "PITI"). Also add in flood insurance and mortgage insurance. If you're looking at a condo, add in assessment fees. It's your total housing cost.
The bottom part of the fraction sums up all your income. If you're buying with a spouse or partner, add up your salaries. If you're a freelancer, be sure to capture all your sources of revenue. "The bank will request transcripts of your tax returns and does an analysis," says L'Heureux. Then comes the math part. This ratio of your housing costs and your income gets converted to a percent. Lenders do not want the housing ratio to be much higher than 33 to 35 percent.
Your lender will look at a second ratio that takes into account all your debt, meaning your proposed housing expenses, plus all of your other long-term debt: student loans, car payment, credit card debt, maintenance or child support and installment loans. "For conventional loans, it does not include your gas and electric bill," says Tim Magee, president of Magee Mortgage Associates. "It doesn't include groceries or anything that doesn't show up on your credit report." Forty-five percent is a good reference number. Keep in mind that Freddie Mac and FHA may accept a back-end DTI over 45 percent in some cases, Fannie Mae raised its 45-percent limit to 50 percent in June 2017 and VA caps loans at 41 percent, a number that can go higher if credit score and money in reserves are stellar.
You say you have a credit card balance you're embarrassed about? To avoid an uncomfortable situation, disclose the debt upfront rather than waiting for your lender to see it during the credit report review. Then work with your lender to establish a pay-back strategy.
You may be able to buy more house than you think, says L'Heureux. "People are surprised by how much a [back-end] DTI ratio of 45 percent allows them to buy," he says. "If a person makes $75,000, you can finance up to $300,000 for a house." Be sure to work with a lender who makes you feel comfortable, offers a competitive rate and can help you determine a price range that is reasonable.