What Are Debt to Income Ratios ?

by Dian Hymer.

If you talk to a lender about what size mortgage you can afford, you're bound to run into the term "ratios". Don't let the lingo put you off. A ratio is simply a relationship between two variables. It's a rate or a percentage.

For example, let's say that one of every two voters favors a tax cut. In this case, the ratio of voters who favor cutting taxes is 50 percent. One divided by two is one-half or 50 percent.

Lenders take two ratios into account in qualifying borrowers for mortgages. One is the ratio of the monthly housing expense to the borrower's gross (pre-tax) monthly income. This is called the front-end ratio.

The monthly housing expense is made up of principal, interest, property taxes and insurance--otherwise know as the PITI. Homeowner's association dues and a mortgage insurance premium are added to the PITI in qualifying borrowers, if applicable.

Let's say your gross annual income is $60,000, which gives you a gross monthly income of $5,000 ($60,000 divided by 12 months). If the lender says that your front-end ratio can't exceed 32 percent, this means that your PITI divided by your gross monthly income must equal 32 percent or less.

To calculate the front-end ratio, multiply your gross monthly income ($5,000 in this example) by .32. The result, $1600, will have to cover your monthly housing expense.

The other ratio is called the back-end ratio. This is the ratio between the borrower's total debt (PITI plus other monthly debt payments) to the gross monthly income. If the lender says that your back-end ratio can't exceed 38 percent, this means that your total monthly debt, including the PITI, must be no more than 38 percent of your gross monthly income.

Now multiply the gross monthly income of $5,000 by 38 percent (.38). The result ($1900) is your back-end ratio. This means that you can have up to $300 in monthly debt in addition to the PITI and the lender will still qualify you for a loan with a PITI of $1,600 ($1,900 minus $1,600 = $300).

If your monthly debts (for car payments, student loans, credit card balances that won't be paid off in a few months) exceed $300, your back-end ratio will exceed the 38 percent lender guideline. In this case, the lender will probably still give you a loan, but a smaller loan than if you had less debt.

If a lender says your ratios are 33/39, this means that your front-end ratio is 33 percent and your back-end ratio is 39 percent. While most lenders take both ratios into consideration, some lenders make exceptions. FHA qualifies borrowers based on the back-end ratio alone.

First Time Tip: What can you do if your ratios are low and you can't qualify for a large enough mortgage to buy a suitable home?

One option is to go to a portfolio lender that doesn't sell loans to investors. These lenders have flexibility in approving borrowers; they can make exceptions, if they want to, for borrowers whose ratios deviate from the guidelines. Some portfolio lenders will go as high as 38 percent on a front-end ratio; some will go higher.

Often lenders will approve a loan with a high front-end ratio if the borrowers have no other outstanding debts, or if they make a large cash down payment.

The Closing: Borrowers with high debt-to-income ratios may be able to get a loan approved if they pledge assets as collateral, or if they open an account with the lender from which monthly mortgage payments can be automatically deducted.

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