In last week’s blog entry we described four important concepts to understand when purchasing your first home. One the concepts mentioned was your debt-to-income ratio or DTI. This week I’d like to expand on the concept of DTI and its implications on the home loan process.
There are two basic types of DTI that lenders will review when it comes to making sure you qualify for home financing. The first is called your “front-end” ratio, which equates to your total projected housing payment on the new loan (which includes the principal and interest payments on your loan along with property taxes, homeowner’s insurance, mortgage insurance and things like homeowner’s association dues and/or flood insurance as applicable) divided by your gross monthly income. As an example, let’s say your total housing payment comes out to $1,000/month and your gross monthly income is $5,000. This would equate to a front-end ratio of 20% as $1,000 / $5,000 = 20%.
The second and often times more substantial type of DTI is what’s called the “back-end” ratio. The back-end ratio is essentially what we referred to simply as “DTI” last week; it’s calculated by adding up ALL of your monthly debt obligations (including your total projected housing payment) and dividing that number by your gross monthly income. To build upon our previous example, let’s suppose that in addition to your projected housing payment of $1,000/month you also have an auto loan payment of $325/month, a minimum credit card payment of $75/month, and a student loan payment of $100/month. In this scenario your back-end ratio would equate to 30% as $1,500 ($1,000 projected housing payment + $500 in other monthly debt obligations) / $5,000 (gross monthly income) = 30%. As discussed in last week’s entry it’s important to note that things such as health insurance, groceries, cell phone bills, 401K, union dues, etc. aren’t included in the back-end ratio. Debt obligations that ARE accounted for in your back-end ratio include the items mentioned in our example above and things like child support, alimony, furniture store account payments, etc.
In terms of qualifying for a home loan, the maximum front-end and back-end DTI ratios that a lender can accept depend largely on the guidelines of the loan program(s) for which you have applied. For instance, with a standard FHA loan, you can be qualified with a back-end ratio as high as 55% or more depending on various characteristics of your loan scenario (i.e. amount of reserve funds, credit profile, length of time with current employer, etc.). On the other hand, with a conventional loan the maximum allowable back-end DTI is lower at 45%. As a general rule of thumb the USDA RD loan program has DTI restrictions of 29%/41% (front-end/back-end). However, similar to the FHA loan program, higher back-end ratios are allowed (up to 46%) depending on the particulars of your loan scenario. Lastly, with VA loans a special calculation called “residual income” matters more than DTI and as a result it is not uncommon to see back-end ratios of 60% or more be approvable.
As you can see, DTI is a complex and important factor in determining your eligibility for a given loan program. As such, working with a lender that understands the general nuances of each loan program and the applicable DTIs is a critical step to ensuring your loan process starts off on the right foot.
Thanks for reading!