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To qualify borrowers for home loans, lenders use several guidelines. One of the more important guidelines is the debt to income ratio, also known as DTI. The debt to income ratio is expressed as a percentage and relates a borrowers debt to their gross income. For example, an overall debt to income ratio of 30 percent would suggest that a borrower’s overall debt makes up 30 percent of their gross income.
There are two types of DTI analyses most home loan lenders will employ to further qualify their potential borrowers. These are the:
- Front-end DTI
- Back-end DTI
Front-end DTI
The front-end DTI ratio expresses the relationship between the borrower’s mortgage debt only and their gross income. This is helpful for lenders to understand how much of a borrower’s income is going to be used on just the loan for which they are applying. For example, a borrower with a gross monthly income of $3,000 per month applying for a loan that would cost $1,000 per month would have a front-end DTI ratio of 33.3 percent ($1,000 / $3,000 = 0.333 = 33.3 percent). Lenders like to have borrowers with ratios under 31 percent, but in some instances may extend loans for ratios of up to 38 percent.
Back-end DTI
The back-end DTI ratio expresses the relationship between the borrower’s total outstanding obligations and their gross income. The back-end DTI analysis casts a wider net than the front-end analysis and includes such things as credit card debt, lines of credit, student loans, car payments, and other secured and unsecured debt obligations. This is an important figure to understand as it gives the lender an idea of the borrower’s total monthly or yearly obligations and how much spendable cash they might have left over for normal living expenses like groceries, medical treatment, and day to day needs.
Lenders do not want the borrower to have too much outstanding debt because it puts their loan at risk of default. Most lenders want to make sure their borrower’s back-end DTI ratio stays below 45 percent. That means a borrower’s total debt payments must be less than 45 percent of their gross income. For example, a borrower with gross monthly income of $3,000 per month, credit card payments of $400 per month, a student loan of $100 per month, a car payment of $250, per month and a proposed home loan $1,000 per month would have a back-end DTI of 58.3 percent. Here’s how that is calculated:
- Total debt = $1,750 ($400 +$100 + $250 + $1,000)
- Gross income = $3,000
- Back-end DTI = $1,750 / $3,000 = 0.583 = 58.3 percent
In our example, this borrower would probably not be extended a loan costing $1,000 per month. Their front-end ratio might be within acceptable ranges, but their back-end DTI ratio too high. The lender would lower the loan amount to make the payment come down, thus lowering the back-end DTI to an acceptable range.
The Final Word on Debt to Income Ratios
Each lender sets their own standards as to what is an acceptable debt to income ratio. In most cases, conventional lenders opt for lower ratios than their HUD and FHA counterparts, who look to make loans accessible to a wider audience. Knowing how lenders use DTI analyses can make you a more prepared borrower. Understanding debt to income ratios can also guide you as to how much debt you should or should not take on as a consumer.
