You apply for a mortgage and your goal is to get the lowest interest rate possible. You aren’t alone. You probably focus a lot of effort on your credit score. You figure that’s the one thing lenders use to decide your interest rate. You are partially right, but there are a few other factors they consider including your debt-to-income ratio.
Lenders look at the big picture when qualifying you for a loan. They want to know that you are a good risk all around. You could have the best credit score but still be in over your head in debt. While your credit score says that you aren’t a high risk, your debt-to-income ratio says otherwise.
Let’s look at how your DTI can affect your interest rate.
The Housing Ratio and Your Interest Rate
Your housing ratio is the comparison of your monthly housing payment to your gross monthly income. The higher the housing ratio becomes, the lower the likelihood of you paying the mortgage on time becomes. If you need a loan that puts your housing ratio close to the program’s limits, you can expect the lender to give you a higher interest rate.
Lenders charge the higher interest rate to make up for your inability to pay the mortgage. They aren’t saying that you can’t pay the mortgage. What the higher interest rate says is that the lender is protecting themselves should you default. With a higher interest rate, the lender makes money when you do pay your mortgage.
The Total Debt-to-Income Ratio and Your Interest Rate
Your total debt-to-income ratio is the comparison of all of your monthly debts to your gross monthly income. Your total DTI includes things like:
- Minimum credit card payments
- Installment loan payments
- Any other housing payments you have
- Student loans
The total DTI lets lenders know how much of your income is already accounted for each month. If the number is too high, (over 43%) you may not get approved. If it’s below, but close to 43%, you can count on a higher interest rate because the lender is taking a large risk by giving you a loan.
Can a Low Debt-to-Income Ratio Help?
A low debt-to-income ratio could have the opposite effect on your interest rate. If your DTI is low enough (either housing or total), you may get a lower interest rate. Lenders prefer borrowers that pose little to no risk of default on their mortgage.
Does this mean that if you have a low DTI that you will automatically get a low interest rate? Unfortunately, it doesn’t mean that. Lenders look at the big picture. They want to know what all of your factors look like when combined. For example, do you have a high credit score and a low debt ratio? If so, you stand a good chance to get a lower rate. If you have a low credit score and a low debt ratio, you may not have that good fortune since your low credit score signifies that you may be a credit risk.
Compensating Factors Help
No matter what your debt-to-income ratio is, you can try to offset it with some compensating factors. These are factors that let the lender know that you aren’t as high of a risk of default as they thought. Compensating factors include:
- Reserves on hand – If you have liquid assets that you can go to should you have trouble paying your mortgage; the lender may count them as reserves. They measure the money that you have based on the number of months of mortgage payments it would cover.
- High credit score – We touched on this topic already, but it’s worth mentioning again. A high credit score shows lenders that you are a good risk. In other words, it shows them that you pay your bills on time.
- Stable employment history – You should have a two-year employment history with the same employer whenever you apply for a new mortgage. While it’s not necessary, it’s another way to show lenders that you are stable and reliable. If you switch jobs often, you pose a higher risk for lenders because your income becomes unpredictable.
The bottom line is if you want the lowest interest rate possible, you need to make all of your qualifying factors look good. If you have a low debt-to-income ratio, you put yourself in a great position to get a low rate. It helps if you also have a high credit score, money as reserves, and a stable employment history.