One of the key components of mortgage underwriting is the prospective buyer’s debt-to-income (DTI) ratio.
A DTI ratio is a way to measure a potential borrower’s overall financial health. It shows the lender, if the loan is approved, the percentage of the borrower's monthly income will be required to pay all of their current monthly debt payments.
Why mortgage lenders pay attention to DTI
Having too much debt increases the risk of defaulting on the mortgage. That’s why traditional home loans limit the total amount of debt borrowers can have in order to be approved.
This is determined by analyzing the minimum amount of your monthly income goes toward debt, and the percentage of your total income that would pay debt once you assume a mortgage payment. Currently, the maximum debt to income ratio for qualified mortgages is 43 percent.
How mortgage lenders determine your income
To determine your income, lenders review your gross income, which is your income before taxes. Typically, lenders will only consider income that is documented through payroll stubs and tax forms.
If you earn a regular salary, the calculation is pretty straightforward. Irregular income requires lenders to evaluate how often you can count on extra funds.
For example, if you received a signing bonus when you started your current job, the lender likely will not consider that in your income projection since it was a one-time amount.
Investments, including real estate, are also not typically considered unless they pay regular dividends or rental income. These sources would need to be documented for the lender to take them into consideration.
If you're eligible for regular bonuses, the lender will review the total amount of bonuses you have received over a period, typically two years. They will then average that amount to determine a monthly figure for the purposes of determining your monthly income.
How mortgage lenders treat self-employment income
The same two-year assessment also applies to self-employed business income. The lender may, however, accept less than two years of self-employed income if you were previously employed in the same field before starting your business.
Since business income can fluctuate, lenders want some assurance that you will continuing earning a certain amount of money from your venture.
For example, if your annual net income was $85,000 two years ago and $100,000 last year, the lender will not consider you to have income of $100,000. They will average the two years to arrive at $92,500. Then they will divide that by 12 months to get a monthly income of $7,708.
To verify self-employment income, lenders will request a variety of documents, including tax returns. They may also request statements from your accountant, if applicable, as well as a copy of your business license.
Unlike with salaried income, lenders use your net business income when calculating self-employment income, not your gross revenue. However, the lender will include non-cash expenses like depreciation and amortization as part of that income.
How mortgage lenders calculate debt
When mortgage companies look at your debt, they evaluate it from two angles.
One is simply a look at the regular housing costs of your mortgage. This is the percentage of your income required for your mortgage payment, including taxes and insurance, as well as homeowner association dues.
The second is the rest of the debt and obligations on your DTI ratio. This will include credit card payments, car loans, student loans, child support, alimony, store credit payments, and personal loans. When determining your monthly obligations, the lender will consider what your current minimum monthly payment is.
How physician mortgages differ from conventional mortgages
Because of their specific DTI requirements, conventional mortgages don’t always work well for physicians. This is especially true for those who may still be in residency or have just started their practice and don’t have the requisite past income. It can also be challenging for new physicians to stay under the DTI requirements due to the heavy amount of student loan debt they carry.
That’s why several companies have created physician specific mortgage products.
Mortgages that have been created specifically for physicians allow them to close on their homes before they begin work, provided they have a contract or offer letter. Self-employed medical professionals can qualify with as little as six months of historical income, versus traditional mortgages that require two years worth of 1099s.
In addition, physician loans either recalculate the impact of student loan debt or dismiss it altogether. This lowers the applicant’s DTI ratio, making it easier to qualify.