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Why Debt To Income Matters | What is the Meaning?

Introduction

If you are considering buying a new house or looking at various student loan refinancing options, it is time to pay heed to your debt to income ratio.

People often think that having a good credit score and a decent sum of money in the bank account are the only pre requisites for qualifying for a good loan.

But having a low debt to income ratio is just as important.

The below article will help you to understand the finer details of the debt to income ratio so that you are well informed about the mortgage lending process.

Page Contents

What is debt to income ratio?

Debt to income ratio (DTI) is a comparison between the person’s debt obligations and his income. It is one of the factors lenders take into consideration that helps them to understand the borrower’s ability to repay the loan.

Debt to income is represented as a percentage and is calculated using the below formula.

Debt to income = Total monthly debt/total monthly gross income

Borrowers who have a high debt to income are considered high risk and their chances of getting approved for loan may be limited.

But there are exceptions to this rule. Based on the credit score, savings and down payment, borrowers with high ratios may be eligible.

Why is debt to income ratio important?

Debt to income ratio is a critical factor that is used to determine if you are the right candidate for receiving the loan. It also provides a sneak peek into your financial health.

Debt to income ratio is important for banks to estimate the monthly loan repayment amount taking into consideration your gross monthly income and total debt.

The DTI ratio allows the bank to arrive at the amount of loan amount and also the interest rate at which they are willing to give the amount.

The debt to income ratio protects the borrowers from taking a home loan they cannot repay. This also helps to protect the bank’s bottom line.

If your debt to income ratio is low, then it indicates that you will be able to repay your debts. If your debt to income ratio is high then it indicates that you will face difficulties in repaying back your loan obligations.

A high debt to income ratio can have the following negative impact on your life.

  • Act as a hindrance for making a big purchase like a house or a car.

  • Money lenders will charge you a high rate of interest and the credit terms may not be the best.

  • You will find it difficult to obtain additional loan in case of an emergency.

What are the different types of debt to income ratio?

There are two types of debt to income ratio namely:

  1. Front end ratio

It is also called the housing ratio. It indicates the percentage of your income that goes towards housing expenses such as monthly mortgage payments, insurance dues, real estate taxes etc.

  1. Back end ratio

This number indicates how much income is required to meet your monthly debt obligations.  Credit card bills, student loans or any other kind of debt that features in your credit report along with monthly mortgage and housing payments are all factors to be considered while determining the back end ratio.

How is debt to income ratio calculated?

Before calculating the debt to income ratio for mortgage, it is important to understand which debts are included and which debts are excluded out of debt to income calculations.

Debt to income inclusions

Debt to income exclusions

All payments made using credit cards Mobile phone bills
Any student loan payment Any utility bills
Any payment towards repayment of auto loans Living expenses such as food, fuel etc
Any payment done towards alimony and child support Bills that do not feature in your credit report
Mortgage payments towards other rental properties or houses Outstanding medical bills
Monthly installment for any loan taken
The new mortgage loan you are proposing to undertake

 

5 debt to income ratio for mortgageIn order to calculate your front end ratio you need to total your living expenses and divide it by your monthly gross income and multiply it by 100.

For example, if your total housing related expenses is $1000 and your monthly gross income is $3000, your debt to income will be 33%.

In order to calculate your backend ratio, total your monthly debt obligations and add it to your housing expenses. Divide the sum by your monthly gross income multiply it by 100.

For example, if your monthly debt obligations include $200 for car loan, $50 for student loan and $100 for credit card bills, then the total will be $1350 after adding the housing expenses from the previous example.

The back end ratio will be 45% based on monthly gross income of $3000.

There are many debt to income calculator available online that will help you to arrive at your debt to income ratio.

Money lenders look at both types of debt to income ratios, but for conventional mortgages, they place more emphases on the back end debt to income as it includes the borrower’s entire debt load.

What is an acceptable debt to income ratio?

If you are wondering what is a good debt to income ratio, then the answer is as follows.

In an ideal scenario, front end ratio should not be more than 28% and the back end ratio should be less than or equal to 36%.

It is best to keep your debt to income as low as possible so that you can qualify for a good loan. A low debt to income indicates that you have stuck the right balance between your debt obligations and income which will help you to repay your loan.

[PDF]Debt to Income Ratio Calculator – Consumercredit.com

How to lower your debt to income ratio?

If your debt to income is higher than 36%, then it is time to take adequate measures to bring it down so that you can qualify for a good loan. You can begin by taking the below steps.

  1. Increase your income

This is the first step towards improving your debt to income. You can ask for a raise in your current job or you work overtime to draw more salary.

You can supplement your income by taking up a part time job along with your regular job.

  1. Repay your debt

You must work towards paying off your debts as soon as possible. You can increase the monthly payment amount and lower your debt quickly.

  1. Do not take additional loans

Reduce your credit card bills and withhold from taking any new loans until clearing the existing loan obligations.

  1. Postpone any big investment

If you are planning on investing in a house, it is better to keep the plan on hold till you have adequate money saved in your bank account.

It is in your best interests to make a larger down payment without taking any loan as it will keep your debt to income ratio low.

  1. Student loan refinancing

If your student loan repayment is putting you under tremendous pressure, you can choose from the many student loans refinancing option to ease your burden.

Is a good debt to income ratio required for unconventional and nonrecourse home loan?

The answer is no. This is the only situation where a good debt to income does not matter as the loan is based on the value of your house and existing equity.

In all other situations, a good debt to income is a deciding factor for banks to grant you a loan. It also affects the interest rate at which the banks agree to give the loan.

What is a Federal Housing Authority (FHA) home loan?

FHA backed home loans are a boon for many home buyers because of its less rigid eligibility criteria. It also offers the following benefits:

  • The minimum down payment of 3.5% is lower than other lenders

  • The credit expectations are within limits

  • Income requirements are flexible

FHA loan providers are more inclusive and are willing to work with borrowers who are unable to meet the strict the requirements of conventional loans. Borrowers seeking an FHA loan have to have a credit score of 500 to be eligible.

Borrowers who have stable employment and documented salary slips are eligible for FHA loan. In general the borrower should have been on the rolls of the company for a continuous period of two years and are expected to continue employment for the 3 next three years.

5 What is an acceptable debt to income ratioWhat is the FHA debt to income ratio?

As per the guidelines laid down by the FHA, borrowers can have a front end debt ratio of 31% and a back end debt ratio of 43%.

This means that the borrowers should not have any housing related expenses greater than 31% of his gross monthly income. Also the borrower’s total debt should that includes the car loans, credit card bills, mortgage etc, should not be greater than 43% of his gross monthly income.

Do you have a high debt to income ratio?

If your debt to income ratio is over the prescribed limits, it may be difficult to qualify for FHA loans. But there are few exceptions to the debt to income ratio you can take advantage of.

As long as the borrowers can demonstrate that they have significant compensating factors, the mortgage lenders may show some leeway and allow borrowers with high debt to income ratios.

Below is a list of compensating factors:

  • Down payment

The minimum down payment for FHA loan is set at 3.5%. If you are able to pay a down payment that is higher than the minimum requirement, you can become part of the exception.

For example, if the borrower has a debt ratio higher that the set caps of 31% /43%, but is able to pay a down payment of 10%, he would still be eligible for seeking a FHA mortgage loan.

  • Payment history

If you have successfully closed a mortgage payment which was greater than or equal to the estimated payment on the loan you are presently applying for, you may still be eligible for the FHA loan.

  • Savings

If you have been weary of using credit in the past, then this may work in your favor. Minimal use of credit and ability to save money can help you to qualify for FHA loan even if your debt to income ratio is high.

  • Good credit

Having a good credit score can increase your chances of becoming eligible for FHA loans. Your credit history will help you to avail the FHA loan even if your debt ratios crosses the minimum requirements.

  • Cash reserves

If the borrower has saved an amount which is greater than or equal to 3 months of mortgage payment, then lenders will make an exception to such borrowers. The high cash reserve will provide a great push for you to become eligible for FHA loan even with high debt to income ratios.

  • Minimal increase 

If the FHA loan amount that is currently being pursued does not have a significant impact on the borrower’s housing expense, the lenders will still be will to make an exception.

Conclusion

One should always bear in mind that the more debt you pile on by taking housing loans or recurring debts, the higher your debt to income ratio will be. This is directly proportional to the level of financial risk you will be exposed to.

Therefore it is important to monitor your debt to income ration on a quarterly basis to stay away from being suck into debt. You must avoid impulse buying and think twice before using credit cards for daily purchases. Being aware of your debt to income ratio has the following advantages:

  • You will be better equipped to make the correct financial decisions regarding taking a new loan.

  • You will avoid making unnecessary credit card purchases.

  • You will be able to save for the future wisely.

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