Debt-to-Income Ratios
The Basics Behind Debt-to-Income Ratios Lenders use a borrower’s debt-to-income ratio – or the percentage of the borrower’s monthly gross (before taxes) income that goes towards regular monthly debts – to determine the maximum mortgage amount that the borrower can afford. Debt-to-income ratios involve two calculations: a “front” ratio and a “back” ratio, usually written in fraction form (e.g. – 33/38). The difference between the front and back ratios is simple. The front ratio is the percentage of a borrower’s monthly gross income that is used for housing expenses, including such things as principal, interest, insurance, taxes, and, when applicable, homeowners association fees and mortgage insurance. In other words, the front ratio indicates the portion of one’s monthly income (before taxes) that the lender allow for housing costs. The back ratio is identical, except that it also includes monthly recurring debts (i.e. – credit card debt, car loan note, child support, and other long-term debts, not including things such as car and life insurance). The standard for debt-to-income ratios is often put at 33/38. This means that the borrower’s housing expenses take up 33% of his/her monthly income; when monthly recurring debt is added to those housing expenses, the borrower’s total financial obligation should not exceed 38% of his/her gross monthly income. For example, if a borrower’s monthly gross income is $4,000, then using the 33/38 standard, the borrower’s maximum monthly housing cost is around $1300 (4000 x .33). When considering recurring debt as well as housing cost, the borrower’s maximum monthly debt expenditure is around $1500 (4000 x .38). This means that the borrower’s total monthly expenditure for housing costs and regular monthly debts should not exceed $1500. The debt-to-income ratio is only one of many factors lenders consider when determining a borrower’s loan capacity. Furthermore, the 33/38 standard is just one benchmark, and guidelines regarding debt-to-income ratios are flexible. Factors such as down-payment amount, borrower’s credit rating, etc., can make a difference in determining just how rigid those guidelines are. Different loan programs have different standards as well; for instance, another conventional loan debit limit is marked at 28/36, while FHA loan ratios are typically 29/41, and VA loans use no front ratio, only a back ratio of 41%. |
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