Recently, Fannie Mae, the government-sponsored enterprise that helps to determine home loan guidelines, increased the debt-to-income ratio that lenders use to determine what size mortgage borrowers qualify for.  Borrowers may not be familiar with Fannie Mae because it is not a direct lender but it plays a very important role in the home loan process.  Fannie Mae buys mortgages from lenders which in turn enables them to issue more loans to borrowers.  Fannie Mae is the largest purchaser of mortgages in the country so when it changes a rule or regulation the impact on the mortgage market -- including both lenders and borrowers -- is significant.

Fannie Mae’s decision to increase the borrower debt-to-income ratio is one of the most important home loan guideline changes in years because it directly affects how much mortgage borrowers can afford. A debt-to-income ratio represents what percentage of your monthly gross income you spend on debt expenses including your mortgage payment, property tax, homeowners insurance and homeowners association dues (if applicable) as well as other debt payments such as for credit card, auto and student loans plus alimony, spousal or child support payments, if applicable.  In short, if you add up all your monthly housing and non-housing related debt payments and divide that figure by your monthly gross income, the result is your debt-to-income ratio.

The previous Fannie Mae guideline permitted a debt-to-income ratio of 43%, which meant that borrowers could spend a maximum of 43% of their monthly gross income on total monthly debt payments, including total monthly housing expense.  The new Fannie Mae guideline increases the debt-to-income ratio to 50%, which means borrowers are permitted to spend 50% of their monthly gross income on total monthly debt payments.  The increase is important because the higher the debt-to-income ratio, the higher the mortgage amount you can qualify for.

The change in debt-to-income ratio from 43% to 50% significantly increases the size of home loan borrowers can afford according to Fannie Mae rules.  The example below compares what size mortgage a borrower can afford under the new 50% debt-to-income ratio as compared to the old 43% debt-to-income ratio.  In this example, the borrower makes $5,000 in monthly gross income and has $500 in monthly non-housing related debt payments (such as credit card and auto loan payments).  As illustrated by the example, under the new guideline, the borrower can afford a mortgage of approximately $342,900, as compare to a mortgage of $282,900 under the old guideline, an increase of $60,000, or 21%.  Please note that this example makes an assumption for property tax and insurance which vary by county and other factors, but the outcome generally remains the same across all borrower scenarios.          

Based on a 30 year fixed rate loan with a 3.750% mortgage rate

While this example represents only one case, it demonstrates how the new debt-to-income ratio enables borrowers to qualify for a significantly higher mortgage amount, which enables them to buy more home. Borrowers can use our Mortgage Qualification Calculator to determine what size mortgage they can afford based on the new debt-to-income ratio guideline and their specific financial profile

In this example, the borrower could potentially afford to spend $60,000 more on a home.  In other cases, borrowers who thought they could not afford to buy a home in a particular neighborhood may have new options.  And other buyers who thought they were priced out of buying a home altogether may now be able to afford a home.  In summary, the new debt-to-income ratio increases purchasing power and expands the pool of people who can afford to buy a home.

There are a couple of important points to keep in mind about the new debt-to-income ratio.  First, while Fannie Mae rules are guidelines, some lenders may impose stricter internal rules, called lender overlays, which means some lenders may not apply the higher debt-to-income ratio.  FREEandCLEAR surveyed multiple lenders, however, and they all indicated that they are using the higher ratio.

Second, the new guideline does not apply to all mortgage programs.  Government-backed mortgage programs such as the FHA, VA and USDA programs apply their own guidelines and typically use a lower debt-to-income ratio.  Additionally, some lenders may offer proprietary mortgage programs that use a lower or higher debt-to-income ratio.  Borrowers should understand up-front what debt-to-income ratio their lender uses as well as the income and debt inputs used to calculate the ratio.

Finally, while the new debt-to-income ratio enables borrowers to qualify for a higher loan amount, that does not always mean that is the right mortgage for you. The most important factor in deciding what size mortgage you can afford is that your are financially comfortable with your monthly mortgage payment and total monthly housing expense over the long term.  The worst outcome when you get a mortgage is that you end up with a monthly payment that you cannot afford.  Regardless of your debt-to-income ratio or what a lender tells you, it is ultimately up to you to choose a loan amount that you can afford.

This article first appeared on the FREEandCLEAR Blog.  For more mortgage tools and resources please visit FREEandCLEAR.