A debt-to-income (DTI) ratio is one tool lenders use to ensure borrowers can manage their monthly mortgage payments. Learning to calculate your own DTI ratio is also important when you plan to buy a home because lenders will use this information to determine your eligibility for a mortgage. The DTI ratio includes figures you may not consider when you are deciding if you can afford a mortgage, and it factors in only your gross (pre-tax) earnings without considering personal spending on food or clothing.
There are actually two types of debt-to-income ratios: a front-end and back-end ratio.
The debt-to-income ratio uses gross income figures, including pre-tax salary and other regular income, such as rental income, a pension or child support. To determine your monthly income, divide your annual income by twelve.
The expenses included in the equation are fixed monthly payments that would appear on a credit report. This means childcare expenses, groceries, and utilities, for example, are excluded.
The monthly expenses should include the following:
When you have calculated your total gross income and monthly expenses (or debt), you will have your debt to income ratio.
Lenders will examine your front-end ratio to determine if you qualify for a mortgage. The front-end ratio is the proposed monthly housing expenses divided by monthly income. The monthly mortgage payment will include principal, interest, property taxes and homeowners insurance or mortgage insurance (PITI). Your lender will consider your front-end ratio is determining how much you can afford to borrow.
The back-end DTI ratio is the one that includes all monthly debt obligations and more accurately reflects your spending ability.
Lenders typically want to see that you have a front-end ratio of no more than 33% with a back-end ratio of no more than 45%. Of course, this is just a guideline. If you have excellent credit but substantial debt, a lender may be willing to go a bit above these ratios to grant you a larger mortgage.
If you get an FHA loan or a VA loan, be aware there are looser guidelines. The FHA will allow borrowers with a front-end ratio of 31% and a back-end ratio of 43%. The VA accepts strong borrowers with over a 50% back-end ratio.
With the new Qualified Mortgage rule that took effect in January 2014, there is a DTI ratio cap of 43% for a loan to be considered a Qualified Mortgage, which grants lenders greater legal protection if the loan later turns bad by ensuring the loan is safe.
Dodd-Frank allowed for two QM standards when it was implemented, allowing a "temporary" exemption from the 43% DTI ratio for loans that can be sold to Fannie Mae and Freddie Mac. Lenders are allowed to make loans that are not considered a QM if they wish, but they may come with higher rates and fees.