When you purchase a home and take out a mortgage, you might not realize that the interest rate you pay on this type of loan can change. If you have an adjustable-rate mortgage, for example, the lender can change your interest rate in certain cases and this may result in you paying more in interest. Mortgage rates around the country also change periodically based on a variety of factors, such as inflation or the country’s economic growth. The interest rate you pay has a large impact on how much you actually pay to own your home over time, and you may decide to refinance your mortgage to obtain a lower interest rate (and subsequently get lower monthly payments).
The process of qualifying for refinancing has many similarities to qualifying for an initial mortgage loan in the first place — refinancing is essentially the process of getting a new home loan (with preferably better terms) that pays off your old mortgage. And, similarly to getting a conventional mortgage, one of the biggest factors that impacts your credit and determines whether a lender will refinance your home is your debt-to-income ratio. If you’re considering a refinance, learn how this ratio impacts a loan, along with the general ratio mortgage loan refinance lenders look for.
What Debt-to-Income Ratio Do Mortgage Refinance Lenders Prefer?
A debt-to-income ratio is the percentage of your or your household’s monthly income that goes towards paying recurring debts compared to your total monthly income. This ratio should be as low as possible because a lower ratio means that you have less debt relative to your income and that you can easily adjust to paying new debts — such as a new mortgage payment.
Some lenders also consider a more specialized type of debt-to-income ratio called the front-end ratio. This ratio considers the percentage of your total income that goes only towards paying housing expenses. Mortgage payments, homeowners association dues, property taxes and homeowners insurance are all considered housing expenses for this ratio.
The exact debt-to-income ratio that a lender will accept depends on both the lending company and the loan product you’re applying for. However, there are some general industry standards you can expect to encounter. Most lenders prefer a debt-to-income ratio of no more than 36% with a front-end ratio of no more than 28%. In other words, your total monthly debts, including estimated expenses for the proposed mortgage loan, should equal no more than 36% of your gross monthly income. Of that 36%, no more than 28% should go to your total housing costs. While some lenders are willing to work with applicants who have higher ratios, 43% is typically the absolute upper limit for obtaining a mortgage that meets federal guidelines.
How to Calculate Debt-to-Income Ratios
Debt-to-income ratios (also known as back-end ratios) are fractions or percentages that rely on division. To find your debt-to-income ratio, add up all your monthly bills to get the total amount you pay out on a regular basis. Add up all your regular income from your paycheck and any other sources, such as rental income. Then, divide your total monthly bill amount by your gross monthly income amount. Multiplying this number by 100 gives you the percentage of your monthly income that goes toward paying down debts.
Everything from credit cards to mortgage payments is something you should include in your total monthly bills. You’ll need to add in all recurring expenses you pay every month. It can help to keep a running list; each time you pay a bill, record it. At the end of the month, review the list and add up your total expenditures. Car loans, student loans and personal loans are some examples of debts that make up total monthly bills. Incidental or one-time costs, such as the cost of paying a plumber for repairs, don’t factor into your debt-to-income ratio. In addition, your gross income is income before deductions. In other words, it’s the total amount you earn, not the total amount you have available to spend.
A person who makes $3,000 per month in gross income and has $1,500 in monthly bills has a debt-to-income ratio of 50%.
- $1,500 / $3,000 = 0.5.
- 0.5 x 100 = 50, or 50%
If this same person pays $900 per month towards their mortgage, homeowners insurance and property taxes, the person has a front-end ratio of 30%. The front-end ratio formula is total monthly housing expenses divided by gross monthly income.
- $900 / $3,000 = 0.3
- 0.3 x 100 = 30, or 30%.
The person in this example would potentially be ineligible to refinance their mortgage because both the back-end and front-end ratios are higher than 36% and 28%, respectively.
Debt-to-Income Ratios and Creditworthiness
Creditworthiness is a measure of how likely a person is to repay a debt. When it comes to mortgage loan refinancing, lenders rely heavily upon an applicant’s debt-to-income ratio to determine their creditworthiness, or how much of a risk it might be to lend to them and how likely they’ll be to make regular repayments. Lenders want to know an applicant is likely to repay the money on time, and creditworthiness provides evidence about that likelihood.
A person with a high debt-to-income ratio spends a large portion of their monthly income on the debts they already have, and they’re at a greater risk of becoming unable to repay their debts. Someone with a lower debt-to-income ratio has a larger percentage of monthly income available that they can put towards paying off a new debt.
In addition, debts aren’t the only expense that the average person has. Debt-to-income ratios don’t consider regular expenses such as food or gas, which can vary each month. Also, the debt-to-income ratio doesn’t factor in unexpected expenses resulting from events like car problems or a trip to the emergency room.
When you have a high debt-to-income ratio, you run a greater risk of not being able to pay all of your bills if an adverse financial event or emergency happens. Because a mortgage is often people’s largest monthly expense, a mortgage lender who refinances for someone with a high debt-to-income ratio is at a greater risk of dealing with missed mortgage payments.
What If Your Debt-to-Income Ratio Is Too High?
Some lenders are more flexible than others. Some lenders refinance if you have a higher debt-to-income ratio when you agree to use your lump sum from a cash-out refinance to pay down debts. The lender will require proof that you’ve paid down the debts.
The simplest way to negotiate with a debt-to-income ratio that’s higher than your lender prefers is to lower the ratio. Lenders are more concerned with how much debt you pay each month than how much total debt you owe. You can also extend the loan term for smaller loans, negotiate lower monthly minimum payments, or pay off smaller debts like credit cards and personal loans to bring your ratio to a more reasonable level. With the exception of paying things off, these actions reduce your monthly debt (and the ratio) even though you still owe the same amount of money.
Debt-to-income ratios serve as a protection for consumers just as much as they do for mortgage lenders. Carefully weigh the advantages and disadvantages of altering your debt-to-income ratio to qualify for a refinance. Even with a lower ratio, the refinance may be unaffordable. Extending other loan terms to qualify for refinancing can result in large long-term interest payments.