Buying a second home
If you are considering buying a second home, lenders will look closely at your Glossary Term: debt-to-income ratio to account for two mortgage payments. Understanding your debt, and how to impact your debt-to-income ratio, can help make you an informed second-home buyer with a strong game plan.
Your debt-to-income (DTI) ratio
When you apply for your second home loan, lenders review how much debt you would pay every month if you added another mortgage. Lenders look at your existing debt payments, plus the new projected mortgage payment for a second home, and calculate what percentage that represents of your total pre-tax income. This percentage is your debt-to-income ratio, which is one of the factors lenders use to decide whether or not to extend a loan.
Lenders often want your debt to be no more than 36% of your monthly pre-tax income; and you’ll have to accommodate both home payments within this percentage. If you can’t afford both mortgage payments (plus taxes and insurance, etc.) and keep within that maximum 36% ratio, you may want to reduce your debt or consider a lower loan amount.
How to calculate your debt-to-income ratio (DTI)
When you apply for a home loan, lenders calculate your debt-to-income ratio by using these steps:
- Add up the amount you pay each month for debt and recurring financial obligations (such as credit cards, car loans and leases, or student loans but not monthly expenses like electric or phone bills). Be sure to include your existing mortgage payment (including property taxes and insurance) in this number.
- Add your projected additional monthly mortgage payment to your debt total from step 1.
- Divide that total number by your monthly pre-tax income. The resulting percentage is your debt-to-income ratio.
For example, if your monthly income is $5,000 and your monthly debts plus your monthly projected mortgage payment are $1,000, your debt-to-income ratio would be 20%.
How to lower your debt-to-income ratio
If your DTI ratio is too high, consider how you can lower it. You might be able to pay down your credit cards or reduce other monthly debts. You may also want to increase the amount of your down payment to lower the projected monthly mortgage payment, or you may want to consider a less expensive home.
You could also consider whether refinancing your current home to pay off other loans and debts could be an option for you. Refinancing is a big step, and it’s not something you should do if you’re planning to sell your home within the next 6 to 12 months or so. But you may be able to pay down higher interest rate debts by rolling them into a lower-interest rate home loan.Footnote 1 This could affect your debt-to-income ratio by lowering your monthly debt payments, or enabling you to pay off your debt more aggressively, or both. But this strategy requires careful consideration before you can really know if it’s the right choice for you—and the financial discipline to not run up the higher interest rate debts again once they’ve been consolidated.
By understanding what your debt picture looks like, you can develop a plan to tackle it. If you don’t know what your debt-to-income ratio is, use our Affordability Snapshot, and we’ll walk you through the calculations in this article.