Looking for the best home loan options possible? There are a few things to know before you begin your Melbourne mortgage application process.
One of the most common ways a lender will determine whether or not you qualify for a home loan and how much you can borrow is your debt to income (DTI) ratio score. Your debt to income ratio is a decimal or percentage that shows your financial capability to pay your current and future debt. It’s based on your current annual and monthly income.
This ratio has become even more important in the wake of the Hayne royal commission. In recent years, the commission found that many lenders had become lax in how they assessed a person’s DTI ratio. The risk there is that a lender lends an amount that the borrower may not be able to service. Now, As Australia’s banking and finance sector shifts towards more responsible lending, many lenders have become stricter in assessing your DTI ratio than they may have been in previous years.
That means this figure is more important now than ever in getting the mortgage you’re after. So let’s look at how you can calculate yours as accurately as possible – and make the changes you may need to get your ratio looking healthier.
Debt to Income (DTI) Ratio Calculator
Fortunately, you don’t have to wait for a lender to calculate your debt to income or DTI ratio. You can easily get an idea of your likely loan approval rate before you apply, using the following equation:
Monthly Expenses (credit card payment+car loan and other liability payments)
Pre-tax Monthly Income
Decimal X 100 = Percentage or ratio
This ratio will determine the percentage of your income that goes towards debt payment on a monthly basis.
When applying for a home loan in Melbourne, the loan amount will be included when calculating your debt. This would now be considered a loan to income ratio or LTI.
Here’s an example.
Loan amount requested: $400,000
Current monthly credit card and other debt minimum payments: $3,000
Total monthly household income: $170,000
Using the DTI formula 403,000 ÷ 170,000 = LTI 2.37
The LTI score indicates your debt is 2.37 times your annual income.
What is a Good DTI?
Of course the debt to income ratio calculator above represents your capacity to repay your loan in a series of numbers. But what exactly does it say about you and your chances of getting approved for your Melbourne mortgage?
Using your scores, a lender is trying to determine your risk factor. It would be irresponsible and unethical for them to supply anyone with a loan (additional debt) that may put them at risk of being in financial distress.
Thus, the lower your loan to income ratio score the less of a risk you become and the greater the chances of loan approval. So, the lower the LTI = higher loan approval rate.
As a very general rule-of-thumb, a borrower can have as high as a 43% debt to income ratio to be considered for a mortgage loan. Ideally, lenders look for a DTI of 35% and below with no more than 27% of that going toward the loan itself.
What about your credit score?
Usually, people assume credit score is the bottom line when determining your mortgage loan approval. While credit score does demonstrate your repayment patterns, it doesn’t provide the entire picture.
Neither do your debt to income ratio (DTI) or Loan to Income (LTI) ratio. Often times, both DTI/LTI and credit score are considered by your prospective lender. However, an impressive DTI/LTI, in some cases, can outweigh an unimpressive credit score.
How DTI and LTI Are Used
Your DTI or LTI won’t usually determine an immediate yes or no from a lender but rather will help them work out how much. Using the debt to income ratio calculator, a lender will calculate your LTI to determine a reasonable loan amount so that the additional financial obligation will be more likely to be fulfilled.
The higher the DTI score, the greater the risk the borrower may be for the lender. This may result in a lesser loan amount – or else a higher interest rate may be applied to the loan.
Improving Your Debt to Income Ratio
So now you’ve done your calculations, you may find that you need to decrease your LTI score or improve your debt to income ratio. Typically, there are two different approaches you could take.
The first approach is to focus on increasing your income. This may take some time, or else not even be feasible for many.
Generally the faster approach is to work on decreasing your debt.
It’s usually easier for a person to decrease their debt, as debt solutions are more widely available than a higher paying or additional job. Practicing regular debt reduction is also a good habit for achieving your long-term financial goals.
Regardless of how much debt you have, the task of reducing it probably isn’t as daunting as it may seem at first. Resolving your debt and improving your debt to income ratio often starts with an honest discussion with your banker or your trusted financial advisor.
Here are some of the options you’re likely to hear from your advisor to improve your DTI ratio and increase your likelihood of a Melbourne mortgage approval:
- Raise your monthly payments toward current debt. This is a subtle but effective way to see your ratio decrease over time.
- Avoid taking on more credit card debt. Hoping for a home loan in the near future? Put your credit cards away, stop using them, while making a higher than average payment to them each month.
- Grow your savings. Having a larger down-payment for your Melbourne property will improve your odds and decrease your risk of rejection.
- Track your progress. Every month recalculate your DTI ratio and watch your score move closer toward your goal.
The approach that is right for you will depend on your personal situation, which is why it’s often good to discuss your situation with a professional and get the right advice for you. If you can do this, improving your debt to income ratio makes you a more appealing candidate for a loan of your desired amount, as it demonstrates your financial responsibility.
Applying for a home loan or any other type of financial borrowing doesn’t have to be a confusing experience. There was a time not long ago when most people would just submit their applications and cross their fingers awaiting the results.
Now that you understand your debt to income ratio – along with your loan to income ratio – you have the tools to be a proactive participant in your loan approval process.
Knowledge is power and there is little more empowering than being able to create the financial future you want. Would you like to get some more specific advice? Maybe just some help getting your DTI where you need it to be? Contact us today for your free consultation on how to get your numbers moving in the right direction.