Monday, 06 April 2020

What Is Debt To Income Ratio?

Written by Posted On Thursday, 13 February 2020 09:15

Most home buyers need a mortgage to buy a home. Getting a mortgage can be quite daunting. 

You will have a whole set of mortgage terms being thrown around.  One of which is debt to income ratio.  So you may be left wondering what is debt to income ratio.

The acronym for debt to income ratio is DTI.  Lenders and real estate agents will throw that acronym around like everyone knows what it is.

Your debt to income ratio is one of the biggest qualifying factor in how much house you can afford.  It is basically the percentage of your gross income that goes towards your debt.

Calculating Your Debt To Income Ratio

Your debt to income ratio is calculated by adding up your monthly expenses and dividing it by your gross income (income before taxes).

When we talk about monthly taxes in context of a mortgage we are talking about:

  1. Rent or Mortgage Payments or in the case of mortgage application a proposed mortgage.
  2. Car Payments
  3. Student Loans
  4. Alimony or Child Support if it is court mandated
  5. Minimum Payment On All Credit Cards

Do not include groceries, utilities or other expenses when calculating your debt to income ratio.

Now you add up all of your monthly debt and divide by your income to get a percentage.  That percentage is the amount of consumer debt takes up of your monthly income.

For example:

Consumer Debt/Expenses = $3300

Your Gross Income = $7800 dollars

3300 / 7800 = Debt to Income Ratio of 42%

What Does Debt To Income Ratio Have To Do With A Mortgage?

Most loan programs allow a debt to income ratio of 41-43%.  This is how a bank determines how much of a house a buyer can afford.

Take the scenario above.  A buyer makes $900 in car payments, student loans and minimum payment on credit cards.  Leaving $2400 a month to go to their monthly housing expense.

The housing expense will include:

Let estimate that the buyer is buying a single family home and is putting 5% down leaving them with a PMI payment.  We will use the following assumptions:

Taxes are $380 a month

PMI is $200 a month

Insurance is $110 a month

That leaves about $1710 left to go towards Principal and Interest on a mortgage.

At a maximum DTI of 43% and an interest rate of 3.75% the price of a home they buy could not exceed about $385,000. 

Different programs have different DTI requirements.  Some can go as high as 50% others below 40% but most loan programs will go up to 43%.

Breakdown of Debt To Income Ratio

In years past the bank break debt to income ratio down into two factions. 

Front End Ratio-  Your front end ratio is your housing expense alone.  Principal and Interest, Taxes, Insurance and Condo Fees are your housing expense.  In the previous example your front end ratio would be 31%.

Backend Ratio- Your back end ratios is your housing expense plus your consumer debt, which we calculated as 42% in the scenario above.

While today's lenders still break down debt to income ration into front end and back end ratios, most do not differentiate between the two.

In years past the government recommended 28% as your front end ratio with a back end ratio being no more than 36%.

What Does DTI Tell The Bank and You?

Your debt to income ratio shows the lender how you handle money. While 43% is the maximum a bank will allow for a debt to income ratio, it is a guideline. 

In some cases if you have a lower debt to income ratio, it will reflect in the interest rate you are offered.   The bank may offer you a lower rate as they will view you as less of a credit risk

When it is all said and done, your debt to income ratios shows home much house the bank thinks you can afford based on your income and expenses.

But as the home buyer you need to be comfortable with payment regardless of whether the bank says they will loan you the money.

 

 Calculate Debt To Income-Qualifying for a mortgage by Kevin Vitali REALTOR®

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