“Debt-to-income ratio“, or “DTI ratio” as it’s known in the industry, is the way a bank or lender determines what you can afford in the way of a mortgage. By dividing all of your monthly liabilities by your gross monthly income, they come up with a percentage. This figure is known as your DTI, and must fall under a certain percent in order to qualify for a mortgage.
The maximum debt-to-income ratio will vary by mortgage lender, loan program, and investor, but the number generally ranges between 40-50%.
Let’s look at a basic example of debt-to-income ratio:
$120,000 annual gross income as reported on your tax returns/pay stubs
- Monthly liabilities: $3,500
- Monthly income: $10,000
- 35% debt-to-income ratio
In this example, your debt-to-income ratio would be 35%. However, the debt-to-income ratio goes into greater detail and comes up with two separate percentages, one for all of your monthly liabilities versus income (back-end DTI ratio), and one for just your monthly housing payment (including taxes and insurance) versus income (front-end DTI ratio).
Front-End and Back-End Debt-to-Income Ratios
So in the above example, if your monthly housing payment makes up $2,000 of your $3,500 in monthly liabilities, your front-end DTI ratio would be 20%, and your back-end DTI ratio would be 35%. Many banks and lenders require both numbers to fall under a certain percentage, though the back-end DTI ratio is more important.
You may see a debt-to-income requirement of say 30/45. Using the example from above, your front-end DTI ratio of 20% would be 10% below the 30% limit, and your back-end DTI ratio of 35% would also have 10% clearance, allowing you to qualify for the loan program, at least as far as income is concerned.
If you’d like to figure out your debt-to-income ratio, simply take your average gross annual income based on your last two tax returns and divide it by 12. Then add up all your monthly liabilities and divide that total by your monthly income and voila. Keep in mind that you’ll need a free credit report to accurately see what all your monthly payments are.
The credit report will show you what your minimum or monthly payment is for each tradeline, which makes it simple to add them up. Some banks and lenders allow installment credit cards such as those issued by American Express to be excluded from the debt-to-income ratio as they often account for thousands of dollars a month, and likely get paid off in full monthly.
The debt-to-income ratio is a great way to find out how much house you can afford, as well as the maximum mortgage payment you qualify for. Simply add up all your liabilities and your proposed mortgage payment plus taxes and insurance to see what type of loan you can take out.
Stated Income to Avoid Debt-to-Income Ratio Problems
Most mortgage brokers that work with potential homeowners will avoid full documentation loans if they feel the borrower won’t qualify for the loan based on their gross income alone. For this reason, banks and lenders offer reduced documentation loans such as SIVA (Stated income, verified assets) loans, and No Ratio (no income, verified assets) loans.
Many people think reduced-doc loans are usually just stretching the truth, but they can also come in handy for borrowers who have increased their gross income recently, or those with complicated tax schedules, usually self-employed borrowers.
Qualifying Rate for Debt-to-Income Ratio
One important thing to keep in mind is the qualifying rate banks and lenders use to come up with your debt-to-income ratio. Many borrowers may think that their start rate or minimum payment is their qualifying rate, but most banks and lenders will always qualify the borrower at a higher rate to ensure the borrower can handle a larger amount of debt.
For example, a borrower may be on a negative-amortization loan program with a monthly payment of only $1,000, but their interest-only payment is actually quite higher, at say $2,500.
For a bank or lender to effectively gauge the borrower’s ability to handle debt, especially once the minimum payment is no longer available for the borrower, the lender must qualify the borrower at the higher of the two payments. This gives the lender security and prevents under-qualified borrowers from getting their hands on mortgages they can’t really afford.
Borrowers should also note that most debt cannot be paid off to qualify. If you have debt on credit cards or other revolving accounts and plan to pay them off with your new loan, their monthly payments will still be factored into your DTI. This prevents a borrower from refinancing their current mortgage or buying a new home and piling all their outstanding debt on top of the mortgage, just to rack up more debt on those cards a month later.
It also allows the bank or lender to gain a true measure of a borrower’s ability to handle debt. However, lenders will usually allow borrowers to payoff installment debt to qualify so long as they have sufficient, verified assets.
Download my Excel Debt-to-Income Ratio calculator below to figure out what you can afford: Debt-to-Income Ratio Calculator
Read more: Do I qualify for a mortgage?
