What’s Your Debt-to-Income Ratio

Debt to Income Ratio - 1855jetdebt.com

Before applying for a large loan (i.e. mortgage or personal loan), learning how to calculate your debt-to-income ratio (DTI) is an important step. It’s a simple measurement that pretty much tells you how much debt you can afford to take on.

Essentially your DTI ratio is the number that lenders will use to determine your loan eligibility. It factors in pre-tax earnings, and does not include personal expenses (i.e. food or clothing).

Calculating Your Debt-to-Income Ratio

Income

To calculate your DTI you’ll have to add your total income and total expenses.

For the income portion here’s what to add.

  1. Annual salary (before taxes).
  2. Rental income from properties you own
  3. Disability or pension
  4. Any other type of regular income

After you’ve added it all, divide the total number by 12 (months).

Expenses

Your monthly expense calculation should include the following items:

  • Monthly housing costs
  • Credit card payments
  • Home equity loan payments
  • Car loan payments
  • Student loan
  • Personal loan payments
  • Monthly alimony or child support
  • Any other standing monthly payments

Don’t include: utilities, groceries, entertainment, childcare, or any out-of-the ordinary expenses.

Lenders want to see a debt-to-income ratio that’s lower than 36%, with no more than 28% of that debt going towards your mortgage.

Mortgage Loan Ratios

When it comes to loan applications there’s two main types of ratios you should calculate.

  1. Front-end ratio
  2. Back-end ratio

For loans, a lender or bank will take a close look at your front-end numbers. And both ratios are useful in estimating how much debt you can ultimately afford.

Front-end Debt Ratio

Your credit score is a preliminary indicator used by lenders. If you pass their minimum requirement a lender will scrutinize your front-end debt ratio to determine your overall credit worthiness.

Your front-end ratio includes your (proposed) monthly housing expenses, divided by your monthly income. A proposed mortgage payment includes:

  • Monthly mortgage payment
  • Homeowners insurance rate
  • Mortgage insurance (PMI)
  • Expected property taxes
  • Homeowners Association fees (HOA fees)

As far as the lender is concerned, the front-end ratio represents the amount a borrower can reasonably afford. It may not reflect the amount you want to spend each month.

Back-end Debt Ratio

The back-end debt ratio more accurately reflects your true spending ability. It includes all existing debt, as described above, plus your new projected monthly mortgage payment.

Dividing your monthly debt vs. monthly income is your back-end debt ratio number.

Example: Current debt is $1,000 per month, and is comprised of $600 toward rent, $250 toward a car payment and $150 in credit card payments. If your mortgage loan is $1,200 per month, add $600 (projected housing payments, minus current housing payments) to $1,000 and arrive at your monthly debt amount of $1,600.

Good Debt Ratio

Lenders want to see a debt-to-income ratio lower than 36%, with no more than 28% of that debt going towards your mortgage. It’s a general example, but if you have a good credit score and don’t carry a lot of debt, in theory you’ll be offered the best mortgage rates.

If you qualify for their loans, the FHA (Federal Housing Administration) and Dept. of Veterans Affairs (VA) have more flexible guidelines when it comes to applying for a loan.

The FHA requires a front-end ratio that is less than 31% of your total income, and back-end ratio less than 43% of total gross income (possibly up to 50%).

Conclusion

Both the front-end and back-end ratios won’t paint the full picture – factors such as down payment amount, net worth (including assets), and credit score all play a part in how big of a mortgage loan you’ll be approved for, and at what interest rate.

It’s not the ultimate decision maker, but knowing how your debt-to-income ratio will help you decide how much you can reasonably spend on a home. Before plunging into a home purchase, calculate your DTI ratios, and carefully consider how much you are truly willing to spend on monthly housing costs.

Published by Todd @ Jet Debt

Graduated with a degree in finance, now I'm a freelance writer :)

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

Create your website at WordPress.com
Get started
%d bloggers like this: