Debt To Income Ratio Explained

Are you trying to get a mortgage loan, a car loan, or even a credit card?  If so, one of the many factors that the lending institution will consider when determining whether or not they will approve your loan is your debt to income ratio.  Your debt to income ratio, which is sometimes referred to as simply your DTI, is determined by calculating the percentage of your monthly gross income that is used to pay your debts.  So, what does this have to do with obtaining a loan and how exactly is this figure calculated?

Why Lenders Care About Debt to Income

Considering your debt to income ratio is important to lenders because it helps them determine whether or not you can afford the loan and if you’ll be able to pay it back.  After all, lenders don’t want to loan money to someone that is in so much debt that he or she won’t be able to pay the bills each month.  In addition to using your debt to income ratio to determine whether or not you will be approved for the loan, this figure may also be used to calculate the interest rate you will be charged.

How Debt to Income Ratios are Calculated

There are actually two different ways to determine debt to income ratios.  One method is referred to as the front-end ratio.  With this method, the ratio is determined by adding up all debts associated with housing costs.  This includes your mortgage principal and interest, your mortgage insurance premium if you are required to carry this extra insurance, your hazard insurance premium costs, your property tax expenses, and any applicable homeowners association dues.

The other ratio is referred to as the back-end ratio.  This ratio considers the same debts as the front ratio method as well as any other debts that you may have, such as car loan payments, credit card debt, student loan payments, alimony and child support, and any legal judgments that have been filed against you.

Using Debt to Income Ratios to Determine Loan Amounts

Lending institutions generally have a debt to income ratio that they use to help them determine how much they will lend to a customer.  They will then have figures to represent the amount of front debt that is acceptable as well as the back debt.  For example, if a mortgage company requires a front/back debt to income ratio of at least 28/36.  This means that 28% of your debt can go toward your home expenses and 36% can go toward payment of all of your debt obligations.

Most conventional loans follow the 28/36 formula, but the FHA generally follows a 31/43 rule.  The VA, on the other hand, generally follows a 41/41 rule of thumb.  Nonetheless, it has become increasingly common to see noncomforming loans that have a back ratio limit as high as 55.

Although it take more than just your debt to income ratio to determine whether or not you’ll get a loan and the interest rates that you’ll qualify for, this is just one more piece of the puzzle that lending institutions use to determine your level of risk.

Be Sociable, Share!

• 

Related Posts:

• Snap Decisions About Income and Creditworthiness Made By Retailers - When you apply for a store credit card, you typically get an answer about whether you qualify right away.  The credit card...
• Distinguishing Between Good Debt And Bad Debt Can Be Complicated - Some people seem to think that debt is debt. No matter how large or how small and no matter the purpose for...
• Household Debt Continues To Hold Back Economic Growth - The state of the US national debt has been getting all the headlines.  While quite problematic, it is household debt that is...
• Think Before Applying for a New Card to Pay Down Debt - Drowning in credit card debt and wondering what you can do to get out of it? If you are thinking about applying...

Tagged as: debt