How it affects your home refinancing options
When you apply to refinance a loan, several numbers come into play. Your approval and the rate you receive will depend on your credit score, your income, and your debt-to-income ratio (DTI). This last number can create confusion for you in the lending process, but makes a big difference in your ability to refinance. Pay attention to it, and look for ways to lower the number for the best refinancing options to emerge for you.
What Is Debt-to-Income Ratio?
Your DTI is the amount of your total income divided by your total monthly income. It includes such obligations as minimum credit card payments, mortgage payments, automobile loans, and child support or alimony payments. It then adds these up and states them as a total percentage of your monthly gross income. So if you make $60,000 per year in salary, your gross income is $5,000 per month. Now, consider the following obligations:
- Mortgage payment of $1,500 per month
- Car payments of $400 per month
- Credit card minimums of $100 per month
This would give you debt obligations totaling $2,000, and a DTI of 40%.
The more you do to lower this number, the more lending and refinancing options you gain. In the above scenario, paying down your credit cards to a minimum of $50 per month, and paying enough down to take your car payment down to $200 per month, would drop your total monthly obligation to $1,750 per month, and reduce your DTI to 35%.
Impact on Credit Score
This is the easy part: your debt-to-income ratio has no impact on your credit score—at least not directly. But the main reason lenders want the number to be low is that a higher DTI can lead to problems if you have unexpected costs arise. The less disposable income you have, the harder it is to navigate financial emergencies. And when that happens, you may fall behind on your payments. So a higher DTI makes you a higher lending risk, leading a lender to charge a higher rate or even deny financing altogether.
Front-End and Back-End DTI
The relationship between your refinancing rate and your debt-to-income ratio can frustrate those looking to lower their payments. Your DTI will decrease if you can get a lower payment, but you may need to lower payments before you can refinance, or before you can get the best rates.
One way you can get past this is to look at the difference between front-end and back-end DTI. Your front-end DTI is the debt-to-income ratio you have before you factor in the new or refinanced loan, and the back-end includes the amount of the new or refinanced loan. So in the above example, if you can refinance your mortgage and lower the payment from $1,500 per month to $1,250 per month, that has the same impact as if you cut the car and credit card payments in half. If you shop around for the right deal, your back-end DTI can make a big difference in your ability to get approved at a great rate.
The Bottom Line
Refinancing a loan can help you lower your payments and your DTI, and improve your overall financial picture. You should know the numbers before you go in, and look at ways you can lower it before you apply for refinancing. A strong budget and debt reduction plan can help you improve your prospects for refinancing across the financial spectrum.
Equal Housing Lender