Debt-to-Income: What It Is, and Why You Should Understand It

In any kind of lending, the organization giving the money wants to be sure that the borrower can actually afford to pay it back. Since a mortgage is typically the largest loan that a home buyer will have, lenders find it important to confirm that a borrower is not taking on too much debt. They use a couple different versions of the debt-to-income ratio to determine how much money a person can reasonably borrow.

What Is the Debt-to-Income Ratio?

People who spend less of their income on housing tend to have more money available for other things, like groceries, utilities, services, and incidental expenses. Homeowners who spend too much on their mortgage payments may not be able to save money in case of an emergency. That might make it harder for them to keep making the payments if something goes wrong . To help prevent this from happening, lenders use industry standards to calculate how much a person should be able to borrow. It is related to their income, debts, and expected mortgage payment. The ratio of debt to applicable income (DTI) ranges from 36 percent to 45 percent or higher, depending on the borrower’s:

  • credit score
  • funds available for down payment
  • employment history
  • assets in reserve

Certain loan programs may require that applicants meet higher restrictions on credit score or down payment in exchange for a higher DTI. While many homeowners understand that 20 percent down payments are customary, there are other options available to them, DTI depending.

How Does DTI Affect Buying Power?

The DTI matters to home buyers because it could seriously restrict their buying power, and thereby affecting their ability to get a mortgage, depending on the conditions in the market where they intend to look. Buyers with no other debts will encounter the first cap on the front-end ratio, since both ratios would be the same for them. Applicants with some other debts could be capped by either the front-end ratio or the back-end ratio, depending on the price of the homes they want to buy, and the total debts they will have to carry outside of the mortgage. Unless people have an income much higher than the regional average, or plan to buy homes that are comparatively inexpensive, their DTI ratio will limit their buying power in some way.

What Is Front-End vs Back-End DTI Ratios?

There are two versions of the DTI ratio. The first is tied to the monthly mortgage payment. This payment is made up of principal, interest, taxes, and insurance. This ratio, known as the “front-end ratio,” relates only the mortgage payment to borrowers’ gross income. Although lenders may set this ratio as low as 28 percent, some loan programs will allow a front-end ratio as high as 31 percent.

The back-end DTI ratio adds the mortgage payment to all the other debts that the borrowers have to make payments on each month. This might include payments that are not officially debts but are still required every month, like child support. Ideally, lenders want applicants to have a back-end ratio of 36 percent of their gross income. However, conventional and government-backed loan programs will approve qualified applicants with a back-end DTI of 43-45 percent. Some lenders may choose to approve loans for borrowers with a total DTI as high as 50 percent, although this is uncommon.

Can One Change Their DTI Ratio?

Fortunately, buyers have some options if they would like to alter their existing debt-to-income ratios. The first is to increase income, while the second involves decreasing debt load. Lenders will consider income from a variety of possible sources, as long as the borrower can adequately document it and its frequency. Although borrowers are not required to document income from a side business, they may choose to do so to improve their DTI. On the other side, people might opt to pay off some debts before they start shopping for a mortgage. Eliminating a certain percentage of monthly payments may decrease the back-end DTI enough to make a difference in buying power.

The debt-to-income ratio is one of the first things lenders look at to determine if an applicant can manage a mortgage. With an understanding of the DTI ratios and how they affect buyers, people can decide if they have what it takes to get a mortgage.

Daniel Ramos loves writing about personal finance, lifestyle, and interior decorating topics. When he’s not writing, he helps design snazzy home interiors in Denver.

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