When a lender examines a loan application they look at several factors, among them the applicant’s credit score, income, and debt to income ratio (DTI). These numbers are important indicators of a person’s ability to repay the loan. It is easy to see why an applicant’s income is examined, and the applicant’s credit score is a numerical representation of their credit history. But what about the debt to income ratio?
A person’s debt to income ratio is important because it is a representation of cash flow – it is the percentage of the monthly gross income that goes toward paying the applicant’s fixed expenses such as debts, taxes, fees, and insurance premiums.
Understanding Debt to Income Ratio
There are two primary types of debt to income ratio used most frequently: the front end ratio and the back end ratio.
Front-End Debt to Income Ratio
The front-end ratio is the percentage of income that pays housing costs. If you are a renter, the front-end ratio is the percentage of income that pays the monthly rent. If you are a homeowner, the front-end ratio is the percentage of income that pays your mortgage principal and interest, property taxes, mortgage insurance premium, hazard insurance and homeowners’ association fees.
Back-End Debt to Income Ratio
The back-end debt to income ratio is the percentage of income that pays your recurring debt payments, such as credit card payments, car loans, student loans, personal loans, child support or alimony payments, legal judgments, or other fixed expenses.
How to Determine Your Debt to Income Ratio
Lenders often use your debt to income ratio to determine whether or not you qualify for a mortgage or other loan. The DTI is often expressed using the notation x/y, where x = the front-end debt to income ratio and y = the back-end debt to income ratio. For example, a lender may require you have a debt to income ratio of 28/36 to qualify for a mortgage:
Determine your monthly income. Take your yearly gross income and divide by 12 months to get the monthly gross income:
$50,000 / 12 = $4,166 monthly income
Determine front-end debt to income ratio. Then take the monthly income and multiply it by the first number in the debt to income ratio requirement; .28, to determine how much of your monthly gross income is allowed or your housing expense.
$4,166 x .28 = $1,166.48
Determine back-end debt to income ratio. Multiple your monthly gross income by the second number in a lenders required debt to income ratio, .36, to determine the total amount allowed for all housing expenses and recurring debts.
$4,166 x .36 = $1,499.76
Debt to income ratios by most lenders do not allow for high amounts of recurring debt payments. As you can see from this example, you only have about $333 a month allowance for car payments, credit cards, student loans, etc.
How to Improve Your Debt to Income Ratio
You have two options to improve your own debt to income ratio. You can either increase your income so you have more money to work with; or you can reduce your debts so your existing income goes further.
If you’re looking to qualify for a mortgage, you’ll need to reduce your recurring debts so that it falls under the lender allowed percentage for your back-end debt to income ratio. Focus on paying off credit cards, loans or judgments and avoid taking on additional debts.
The Importance of Debt to Income Ratio
Your debt to income ratio is important because it is an indicator of how much of your income is spoken for each month. These fixed payments go a long way toward determining whether or not you will have enough cash flow to meet all your financial obligations each month. In general, the lower your debt to income ratio, the better your cash flow and more likely you will be to pay your loans.