Mortgage rules under The Dodd Frank Wall Street Reform and Consumer Protection Act will change on January 10, 2014, affecting both homeowners who want to refinance, and first-time homebuyers who need a mortgage.
If you're wondering which rule change will have the biggest impact on mortgage seekers, the answer is the rule regarding allowable debt-to-income (DTI) ratio. The DTI is your monthly debt repayments (including your prospective mortgage, and any other loan or alimony payments you must make) divided by your gross monthly income (your income before taxes).
"Home loan seekers need to know that the allowable debt-to-income (DTI) ratio for a qualified mortgage under Dodd-Frank come January will be 43 percent," says Grace Keister of First Team Real Estate in Irvine, CA. The lower debt ratio means no more than 43 percent of applicants' incomes can go to paying debt.
Todd Huettner, a Denver, CO mortgage broker and the owner of Huettner Capital, agrees this change is an important one. Currently, traditional conventional conforming loans, like those under the Fannie Mae and Freddie Mac programs, enjoy an automated underwriting approval of up to 45 percent total DTI ratio, Huettner says.
"That two percent difference does not sound like a lot, but it will surprise many people and prevent them from getting a loan," says Huettner.
The 'Ability to Repay' Rule and Qualified Mortgages
According to the Consumer Financial Protection Bureau's (CFPB) publication, "What the new Ability-to-Repay rule means for consumers", prior to the financial crisis, lenders gave mortgage loans to borrowers who couldn't make the payments.
The Ability to Repay rule under Dodd Frank introduces a new mortgage category known as the Qualified Mortgage (QM), which generally allows a DTI of no more than 43 percent, according to the CFPB.
The DTI rule change will especially have a strong impact on first-time homebuyers.
"Dodd-Frank will have a chilling effect on many first-time home buyers that are stretching every dollar to get into a home," says Henry J. Daniels, a senior mortgage adviser in Woodlands, TX. "The lowering of debt-to-income limits on most loans will force some buyers to wait longer and save more to make that first purchase," says Daniels.
Refinancing a Conventional Mortgage
Homeowners planning to refinance may also be affected by the coming Dodd-Frank rules.
"Many may be in a position where they cannot refinance, because even if they lower their payment the DTI may prove to be too high after they roll in the closing costs," says Daniels. He suggests some borrowers may have to pay down the balance of their mortgage to a certain amount at closing to fit in the new debt limits. For example, if their loan balance is $200,000 but they need to get it to $190,000 to be below the maximum DTI ratio limit, they will need to pay their mortgage balance down by $10K to be able to qualify for the refinance.
Other options, such as the 100 percent financing programs of USDA and VA are unaffected by the rule because required DTIs are already below 43 percent. Streamline programs including conventional, FHA, VA and USDA mortgages don't require reviewing DTIs, according to Daniels.
What You Can Do to Prepare for the Change
Though the impending DTI changes may seem like bad news, you can start preparing now to improve your chances of qualifying for a mortgage or refinance.
"Check and see what your debt-to-income ratio is and if it's not at [or below] 43 percent, then from now until January you need to start paying down your debt," says Keister.
Not sure how to calculate DTI? It's easy. "Your debt-to-income ratio is calculated by adding your monthly debt, such as credit card payments and loans, and future monthly housing payments, dividing that all by your gross monthly income and multiplying that by 100," explains Keister. Once you know it, start reducing it.
How to Lower your DTI
"To lower your DTI, you have to either make more or owe less," says Huettner. "Typically, paying down debt is the easiest and fastest way to lower your debt to income."
Huettner says to start with your car loan. "Paying off car loans is the usually the biggest bang for your buck because they are short loans with higher payments compared to student loans, home loans, or even credit cards." Another common tactic is debt consolidation into a home loan or other loan, he says, resulting in a lower payment and lower DTI. However, Huettner cautions mortgage seekers to make these decisions carefully.
"Please keep in mind these tactics to lower DTI are often slippery slopes that cause people to struggle financially. PLEASE BE CAREFUL," he cautions.
He offers a simple tip that many mortgage seekers overlook.
"The best and safest way to lower your DTI is to simply make sure the lender is calculating your income and debt correctly," Huettner advises. "This is why you need an experienced lender."
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