Debt-to-Income Ratio: The Other Financial Health Metric
We talk so much about credit reports and scores, that it is easy to forget that there are other factors lenders consider when determining if we qualify for a loan or for housing. Our debt-to-income (DTI) ratio is one of those factors. The DTI is the percentage of our income that goes toward paying our monthly debts. These ratios can often be overlooked as many people assume that a good credit score and income are the only two elements taken into consideration when seeking to purchase a home, car, or even to open a credit card. However, for many lenders, a good report and credit score are not enough to be considered a suitable candidate. As a borrower, our DTI is also utilized to determine our level of risk. For instance, if our DTI is too high, opportunities to make a big purchase, such as a mortgage, may be limited.
In this blog, we will look at two of the ratios used in lending; the housing front-end ratio (or housing expense ratio) and the housing back end ratio otherwise known as debt-to-income ratio.
The front-end ratio is looking at how much of someone's income can safely and affordably be dedicated to mortgage or rental housing payments.
The back end ratio is measuring how much income is being used for debt repayment - including the mortgage or rent.
Housing Expense Ratio
In general, the front-end ratio should be between 28% and 31% or less of gross income. Our gross income is the money we receive before any taxes or deductions are removed. To calculate the front-end ratio of a mortgage payment, we include principal, interest, taxes, insurance, and mortgage insurance (if we are putting down 20% or less of the home’s cost). That number is divided by our gross monthly income.
For instance, an expected mortgage payment of $1,200 and a gross monthly income of $5,000 would indicate that 24% of someone’s income would go toward their housing payment: $1,200/$5,000 = .24 or 24%. This is good news as it is below the 28% - 31% required to qualify, but we also need to know how that fits with the entire budget. That is where the critical back end debt to income ratio comes in.
For the back end ratio, we are calculating the debt-to-income ratio. This ratio should show that the monthly debt payments are at 36% - 43%, or less, of the persons gross income. Some lenders will allow that percentage to be higher – up to 50% in certain circumstances. But if faced with that situation, be aware it may be a higher cost loan.
Debt payments included in this calculation are:
- Mortgage/Rent payment,
- Student loans,
- Auto loans,
- Credit cards, and
- Other monthly debt payments and obligations including child support or alimony.
|Using our numbers for the house payment we just looked at, we add up all our monthly debt payments and divide them by our gross monthly income.|
|Debt payments are:|
|$1,200||a month for the mortgage|
|$ 350||auto loan|
|$ 250||all other debts|
|$1,800||total debt payments|
|With a gross monthly income of $5,000 the debt-to-income ratio for this person is 36% ($1,800/$5,000 = .36 or 36%).|
Based on their DTI, this person would pass this criterion for borrowing or renting.
The DTI ratio is utilized by lenders as a measuring tool. Our DTI ratio helps lenders determine our ability to manage our finances, specifically, our monthly payments to repay the money we borrowed. Keep in mind that lenders do not know what we will do with our money in the future, so they refer to historical data to verify our income and debt totals and much of that information may come from our credit reports. The credit report, scores, and DTI ratios illustrate that we have a sufficient balance between our income and debt and are more likely to be able to manage our payments. What you are seeing here is very simplified. It does not consider the current economic conditions or the amount of collateral someone may have to help secure a debt.
Using our credit reports, credit scores, and debt-to-income ratios also provides the information we need to feel comfortable about making a major purchase or being confident in our ability to meet our housing costs.
American Financial Solutions’ certified credit counselors can help people find ways to reduce debts and monthly debt payments. They listen and work with consumers to understand their financial situation and budget and then help them develop realistic options for meeting their financial goals. Call or chat with a counselor today at 888-282-5811.
Published Feb 2, 2021.