A large concern on any loan is the debt-to-income ratio. The amount of your monthly income that is already spoken for with debts is a concern for lenders. They don’t want you to over commit yourself. This poses a large risk for default. Generally, loans cannot have a total debt ratio that exceeds 43%. This is for Qualified Mortgages. However, since stated income loans do not fall within the QM guidelines, you may find lenders willing to go as high as 50% on the DTI. Regardless of the maximum DTI a lender allows, it helps to know how they calculate this ratio when you state your income.
Verifying Your Income
Stated income loans today do not mean the same thing they did 10 years ago. Today, you still verify your income. You just do so in an alternate way. For example, if you own your own business, you may not want to provide your tax returns for income verification because of the expenses you write off. If your bottom line is not high enough, your debt-to-income ratio will be too high for approval purposes. In this case, you may want to use your bank statements in exchange for your tax returns. In order to do so, you have to find a private lender who keeps the loans on their own books. These lenders are the type who offers alternative documentation loans.
You may find a few other programs with different lenders. For example, you may be able to provide just your W-2s and not your tax returns. Maybe you have unreimbursed employee expenses that you write off that affect your bottom line. Again, some lenders offer this program. They do so in exchange for a higher interest rate because you pose a higher risk.
Calculating the Debt-to-Income Ratio
If you don’t verify your income the traditional way, how do lenders calculate your debt-to-income ratio? They do it the same way they would if you were to provide your tax returns. Every lender has to use some method to verify your income. Stated income does not mean stated any longer. It just means alternatively verifying your income.
For example, if you use your bank statements to prove your income, the lender will likely ask for 24 months of statements. From those statements, the lender will take an average of your income. If they ask for 24 statements, they will take a 2-year average and if they ask for 12 statements, they will take a one-year average. This income is then what they use to calculate your DTI. They take your total gross monthly income and compare it to your monthly debts.
Keep in mind, the lender looks at all debts reporting on your credit report. Any of the following will be included:
- Mortgage payment (total payment including principal, interest, taxes, and insurance)
- Car payments
- Student Loans (including deferred loans)
- Credit card minimum payments
You will not see things like insurance, utilities, or cell phone payments. The lender does not include these in the DTI ratio.
Your Interest Rate
The program you choose will help to determine the interest rate you pay. You can expect to pay a higher rate simply because the programs have a higher risk. A lender who accepts income documents in the place of the standard paystubs, W-2s, and tax returns automatically takes a higher risk. Granted, your bank statements need to be official, meaning the bank must stamp, sign, and date them, but there is still a risk. The lender will go through your bank statements to ensure the money you say you make is consistently deposited.
Because of the higher interest rate, you will have a higher debt ratio. Most private lenders do not have incredibly strict guidelines for the debt ratio, but they still have something in place. If you have compensating factors to make up for the risk, it could help. Lenders know they have to charge you a higher interest rate, which automatically increases your DTI. In order to make up for the higher DTI, they want to see something that makes up for the risk, such as:
- Several months’ worth of assets
- Many years at the same job or within the same industry if you own your own business
- High credit score
This is just a sampling of ways you can make a lender consider your loan profile less risky despite the fact that you cannot fully verify your income.
Don’t Overlook the DTI
The one thing to keep in mind is that every lender will need to verify your DTI. Whether a lender decides to provide loans under the Qualified Mortgage Guidelines or, not every loan must meet the Ability to Repay Rules. These rules state that the lender did everything in its power to ensure that you could afford the loan they provide you. This means verifying your income in the chosen format and calculating the debt-to-income ratio. These guidelines are in place in an effort to decrease the number of loans that borrowers default on because they could not afford the payments.
Debt-to-income calculations are as important on stated income loans as they are any other loan. You have to prove you can afford the loan or a bank cannot provide it. There are ways to decrease your DTI if it is too high, even for a stated income loan. Start paying your debts down, especially your credit card debt in an effort to decrease your minimum required payment. In addition, making enough payments to decrease your installment loans to just 10 payments can help a lender leave it out of your debt ratio altogether.
In the end, the DTI helps you avoid getting in over your head. It may seem like an obstacle to get the mortgage you need, but do you really want a payment you cannot afford? The calculation helps you keep things affordable and realistic whether or not you are stating your income.