How The Debt to Income Ratio is Calculated

Debt to Income Ratio (DTI)

The “Debt to Income Ratio” is a large part of home loan approval. While it’s not a perfect picture of how every single would be homeowner should be determined worthy of eligibility, and there are factors which can cause the debt to income ratio to be tweaked slightly, there are simple rules of thumb most lenders use as a blueprint for determining whether or not a home buyer can actually afford the property they are interested in.

The debt to income ratio can also be used to create parameters for a loan pre-approval for a buyer to start looking at homes within those price parameters.

DTI Ratios

• Conventional Loans: 28/36
• FHA Loans: 29/41

The front ratio qualifies buyers based on the housing payment divided by the buyers qualifying income.

The back ratio qualifies buyers based on the housing payment plus the monthly debt obligations, divided by the buyers qualifying income.

The debt to income ratio can be determined in the following manner, with simple information from the buyer about their annual gross income and their monthly anticipated bills.

Front End Ratio

The first number, called the front-end ratio, is the percentage of the buyer’s gross monthly income that can be comfortably spent on housing payments or a mortgage.

To find this number, the buyer simply divides their gross annual income by 12, then multiplies the resulting gross monthly income by 28% or 29% (.28 or .29). The answer will be the amount a buyer in that income range can comfortably afford to spend on their housing costs monthly.

How Is Your Income Qualified?

W2

For W2ed employees who are paid bi-weekly, the lender with qualify you on your pay stubs, and the gross income. If you receive any bonus income, the lender will review two years’ worth of W2s and will average the bonuses. The average amount of bonus income is added to your gross income.

Self-Employed

For self-employed borrowers who own more than 25% of a business, mortgage lenders calculate income by adding the adjusted gross income from:

• The past two years 1040 tax forms
• A current profit and loss statement (prepared by a CPA)
• The lender will add back allowed, claimed depreciation to the qualifying income.

The mortgage lender then divides the bottom-line figure by 24 months to determine the gross income that is allowable for qualifying for the loan.

Rental Income

Rental income can be used to in the qualification process, but there are very specific guidelines as to what percentages that can be used. Typically 75% of proposed income can be used with proof of signed leases in a 1-4 unit FHA purchase. There are factors that affect this such as vacancy. HUD has guidelines for Geo specific areas on rental vacancy factors. The underwriter can mark-down the percentage of qualifying rent if a property is identified as being in a region that has a higher than normal vacancy rate.

Make sure to check with an experienced mortgage lender, who has experience in qualifying rental income, as qualifying mortgage guidelines can change.

What Is Included In The Housing Payment?

• The loans monthly principle and interest payment
• The monthly real estate taxes payment
• A home owners insurance monthly payment amount (not applicable on condos)
• Mortgage insurance payment
  • Is required for conventional purchase loans with a loan to value over 80% where a second loan or home equity line is not being financed.
  • Is standard on FHA loans, has a monthly payment component as well as a percentage that is financed into the overall loan amount.

Back End Ratio

The second number, called the back-end ratio, is the percentage of the buyer’s gross monthly income that must needs be allocated to all long-term monthly debts combined.

To find this number, the buyer again takes the arrived at gross monthly income, and multiplies it by 36% or 41% (.36 or .41). The answer will be the amount the buyer spends in total on all long term debts combined.

This number can be used to determine an actual limit to the monthly housing cost that can be more realistically accurate than the simple front end ratio. Monthly bills, including car payments, credit cards, child support, alimony, outstanding personal or signature loans, etc. can be added together, and the total subtracted from the back-end ratio. The amount left is the actual amount of money per month that is realistically available to spend on housing.

Benefits of using the debt to income ratio

While a comparatively debt free single person or couple with no serious debts and low monthly costs may be tempted to overspend on a mortgage, the debt to income ratio utilizing the front end number or the back end ratio number manipulated for a closer estimate of available housing designated income can safeguard the future in case circumstances were to change (job changes, family expansion, drops or hikes in home values, property tax increases, etc.)