Debt-to-Income Ratio Explained

Debt to Income Ratio Explained

Debt-to-Income Ratio (DTI) Definition

Lenders want to make sure they are funding mortgages that people can afford. One tool they use, to evaluate a borrower’s ability to pay back a home loan, is a calculation called a debt-to-income (DTI) ratio.

Your DTI ratio compares your gross monthly income to your monthly liabilities, including the proposed mortgage payment. The calculation is simple: take your total monthly debt and divide it by your gross (before tax) monthly income. The DTI ratio will be a percentage (e.g. 40%).

Debt-to-income (DTI) ratios indicate how burdensome it will be for a household to meet its monthly debt obligations. Borrowers with a low DTI ratio should be able to make their ongoing monthly mortgage payment. The cash cushion at the end of each month denotes a margin of safely.

High DTI ratios mean that most of a borrower’s monthly income is gobbled up by their bills. That represents a risky situation for lenders; the borrower’s income is stretched too thin, and they may not be able to make their mortgage payments.

How to Calculate Debt-to-Income Ratio

Each type of home loan program (i.e. FHA loans, VA loans) has guidelines for acceptable qualifying ratios. The rules for each program limit how much of your income can go toward your mortgage, plus all other monthly debt payments. In most cases, two kinds of qualifying ratios are used, housing expense ratio and debt-to-income ratio. We’ll explain both.

First, let’s calculate a housing expense ratio (also known as the front-end ratio). The housing expense ratio compares a borrower’s gross monthly income to the proposed monthly mortgage payment including principal, interest, taxes and insurance (PITI). Extras, like homeowner’s association (HOA) dues, would also be included.

Housing Expense Ratio (Front-End Ratio)

  • Add up all sources of monthly income
  • Add up all the required components of the proposed monthly mortgage payment (e.g. PITI + HOA).
  • Divide the monthly mortgage payment by the borrower’s gross monthly income. The result should be a decimal point followed by a few numbers, the same thing as the percentage. You can convert the result to a percentage in your head or multiply it by 100 if you’re a math purist. Heres the housing expense ratio formula:

Housing Expense Ratio

Debt-to-Income Ratio (Back-End Ratio)

Now let’s calculate the debt-to-income ratio (also known as the back-end ratio). Doing so, we see what the debt burden looks with the proposed mortgage payment and the borrower’s other monthly debt obligations added together.

  • Add up all sources of monthly income
  • Add up all monthly debt payments, including the proposed mortgage payment. Here’s the debt to income ratio formula:

Debt to Income Backend Ratio

Real World Debt-to-Income Ratio Example

Let's find the housing expense and debt-to-income ratio for Mary, a woman interested in taking out an FHA loan. Here's what we know about her:

  • Gross Income (before taxes): $5,000 per month.
  • Debt: all of her debt payments, such as credit cards and student loans, add up to $500 per month.
  • Mortgage Payment: the proposed monthly mortgage payment (PITI) for her FHA loan would be $1500 per month.

Using the housing expense formula above, we can determine that Mary's front-end ratio is 30% ($1,500 ÷ $5,000 = .30).

Now let's find to find back-end ratio, we add Mary’s existing monthly debt payments ($500) to the proposed mortgage payment ($1,500) which gives us her gross monthly debt of $2,000. Then we divide the new debt total by her income.

Her back-end ratio is 40% ($2,000 ÷ $5,000 = .40).

So will Mary qualify for the FHA loan she wants? FHA loans require front-end and back-end qualifying ratios of 31/43. Mary’s ratios are 30/40, well within FHA guidelines. She will very likely be eligible for an FHA-insured mortgage. To be clear, other factors like Mary’s credit score and job stability will also play a role in her loan approval.

Mortgage Program Qualifying Ratios

Each mortgage program has guidelines for front-end and back-end ratios. Qualifying ratios will change a little bit based on whether the loan is:

  • Underwritten manually or through an automated underwriting system.
  • Eligible for purchase by a GSE like Fannie Mae and Freddie Mac or the loan is insured by FHA, VA and USDA.
  • Issued by a small lender (less than $2B in assets and originate fewer than 500 first mortgages per year)

Starting January 10, 2014, most lenders adopted a new underwriting guideline capping the back-end ratio to 43%. That’s because the Consumer Financial Protection Bureau (CFPB) came up with a set of rules that, when met, would certify a loan as a Qualified Mortgage (QM). One of the QM rules sets the maximum back-end ratio to 43%.

Here are the front-end and back-end requirements for a few of the most popular loan programs. Front and back-end qualifying ratios are written as number/number.

FHA Loan Debt-to-Income Ratio

  • Debt ratios, according to FHA loan requirements, are 31/43
  • FHA Energy Efficient Home (EEH) loans allow up to 33/45
  • Because no income verification is needed for a FHA Streamline refinance, there is no DTI ratio evaluation

VA Debt-to-Income Ratio

  • VA guidelines don't specify a borrower’s front-end ratio; only the back-end ratio is used, which is 41%
  • Lenders can make exceptions for ratios over 41% depending on the strength of the borrower’s financial profile and other compensating factors
  • Note: the VA Streamline refinance program does not require a DTI ratio calculation

USDA Debt-to-Income Ratio

  • USDA loan guidelines set the qualifying ratios at 29/41
  • Compensating factors like higher credit scores can also push the qualifying ratios a bit higher

Conventional Loan Debt-to-Income Ratio

  • Most conventional loan programs, like Conventional 97, cap a borrower’s debt-to-income (back-end) ratio to 43%
  • The Fannie Mae HomeReady program allows a slightly higher DTI ratio of 45% and can go as high as 50% with compensating factors such as giving consideration to non-borrower (roommates, boarders and family members) household income.

Debt-to-Income Ratio FAQs

Why do debt-to-income ratios matter?

DTI ratios are used to measure a borrower’s ability to make their monthly mortgage payment. Qualifying ratios do not sit in isolation; they are part of a broader assessment of a borrower’s financial profile. Things like credit scores and employment history also play a role in determining risk. What’s more, the property must also meet mortgage program requirements. Things like the appraised value and structural integrity will also come under scrutiny.

How is income treated if I'm self employed or earn commissions?

All income is treated the same in terms of the DTI calculation. However, mortgage lenders further scrutinize some types of income like commissions, tips and self-employment income. To evaluate income other than W-2 wages, lenders typically ask borrowers for 2 years’ worth of financial records. Lenders can then look at the average earnings over the last two years as a way of predicting future non-W-2 income.

What kinds of documents will I need to prove my income?

Lenders are looking for stable, predictable income. As a part of the lender’s due diligence on the loan file, they will verify the records you provide. You may be asked to provide:

  • W-2s (2 years)
  • Recent pay stubs (30 days)
  • 2 years of federal tax returns if self-employed
  • Recent bank statements (2 months)
  • Investment account statements (2 months)
  • Rental agreements for investment properties

What is a good debt-to-income ratio?

A good DTI ratio is whatever each loan program says it is. That's a cheeky answer, but it's true. You can find the exact qualifying ratios for the most popular loan programs above. In broad terms, an acceptable debt-to-income ratio would not exceed 43%.

What is the Qualified Mortgage (QM) rule?

The QM rule was created partly in response to the mortgage crisis that began in late 2007. A raft of financial reforms sought to make the mortgage and housing markets more stable. The QM rule is a law and set of guidelines that ensures lenders will make a reasonable, good-faith determination of a borrower’s ability to repay their loan.

How do I improve my DTI ratio?

To improve your DTI, you’ll need to earn more, eliminate some of your debt or a little of both. Try to reduce or pay off your debts completely. You can increase your income by asking for a raise or finding a side job. Here’s a no-brainer: don’t open new lines of credit!

What “debts” are included in DTI ratios?

Insurance, utilities and household expenses are typically not included in a DTI ratio calculation. Here are the typical debt components:

  • Proposed mortgage payment
  • Auto loans
  • Student loans
  • Credit card payments (using monthly minimums)
  • Co-signed loans
  • Alimony
  • Child support

What “income” is included in DTI ratios?

  • Monthly income from regular or self-employment
  • Bonuses
  • Commissions
  • Overtime
  • Tips
  • Rental property
  • Investments
  • Alimony
  • Child support

Can lenders make exceptions to debt-to-income ratio guidelines?

Yes, sometimes. If they do, lenders usually charge a higher interest rate or add a fee as a risk premium. Fees typically range 0.25% TO 0.50% on the loan amount. Or the interest rate might get bumped up by .125% or more.

What about student loans?

Regular student loan payments are a normal component of a DTI ratio calculation.

Deferred student loan debt is handled differently based on the kind of loan for which you apply. For conventional loans, you’ll need to get a letter from your creditor identifying the future estimated monthly payments. Lenders will calculate your DTI based on the estimated monthly student loan payment.

You’ll get a little more breathing room with a government-insured loan (FHA, VA, USDA, etc.) If your student loan is deferred for 12 months or longer, it does not need to be part of the DTI calculation.

What if I’ve secured a loan using a financial asset?

If you’ve used a life insurance policy, 401(k) account, individual retirement account (IRA), certificate of deposit (CD), stocks, bonds, etc. to secure a home loan, your repayment to those financial assets is a contingent liability. Lenders do not have to include a contingent liability when calculating your debt-to-income ratio.

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