Financial stability is an important aspect and responsibility that most struggle with. The financial guru Dave Ramsey is known to say that “we buy things we don’t need with money we don’t have to impress people we don’t like.” One of the methods banks or lenders analyzes a potential borrower is through the debt-to-income ratio. In other words, the potential borrower’s responsibility with money.
In this article, you will learn how is debt ratio calculated for a mortgage? This article is part of a series ‘All About Mortgages’ that answers questions for those who seek out a general knowledge on the subject matter.
What is the Mortgage Debt Ratio?
Debt ratio is a percentage of debt compared to income. For instance, if your debt ratio is 20, then your expenses represent 20 percent of your monthly income (gross).
Lenders generally asses the mortgage debt ratio of a loan applicant to assess whether the individuals are capable of loan repayment within the stipulated time. Here, the financial institution evaluates the loan application based on the applicant’s financial stability and income. It also considers any previous debt or loan that the applicant has to their name. The mortgage debt ratio is calculated to evaluate the applicant’s financial standing, to check if their debts exceed a specific fraction of their domestic income or not.
There are two main types of mortgage ratios, a first ratio or front mortgage ratio and a second ratio or backend mortgage ratio. The front ratio is calculated by adding the total monthly expenses of the household including the taxes, insurance and additional interest amount and then dividing it by the individual’s total gross monthly income.
The back-mortgage ratio is calculated by adding all the everyday expenses and other liabilities and dividing it by one’s preceding month’s income. Financial experts have revealed that the mortgage debt ratio is indirectly proportional to an individual’s borrowing capacity. This means that the higher your debt-to-income (DTI) ratio is, the less likely are your chances to get the loan approved. If you are planning to apply for a mortgage loan and want to check your mortgage debt ratio, we have a detailed guide below.
The Need for Calculating Mortgage Debt Ratio
Just like physical health, financial well-being also depends on different factors, some more vital than others. And not all these factors are in your control. For instance, a single person cannot really make a big difference, in the market trends or change the course of a sector. What we can do, is learn how to read the market and invest wisely. Banks and other financial institutions are always on the lookout for business, they encourage people to apply for loans to ensure steady cash flow and expansive investment opportunities. But before a bank or a lender offers a sum of money, they would want some sort of security to minimize their own risk of investment.
Further, an individual doesn’t need to be an expert to understand the mechanisms of a good DTI or the technicalities involved in endorsing loans. It would, however, be prudent if we are aware of the intricate components that contribute to the process. It is common knowledge that banks do not offer money as an act of goodwill. With factors like DTI, credit score and so forth. Banks can evaluate a person’s financial credibility and hence decide whether they are worth the investment. Financial institutes have the foresight to see a profit. Therefore, they will offer loans to invite only people with a low DTI score to invest in their services. It would be better if you calculate your DTI before applying for a mortgage loan. Calculating DTI doesn’t just give you a score or percentage but also paints a vague picture of your financial responsibility.
Decoding: How is Debt Ratio Calculated for a Mortgage?
The DTI ratio is one of the basic factors that mortgage lenders and banks use to judge if you can pay the monthly costs and keep up with paying your monthly mortgage payments. To calculate your DTI, banks add all the monthly debt payments and then divide it by the gross income of the household.
Listed below are the steps you can follow for DTI Calculation.
- Add up your regular expenditures and debts including credit cards, auto loans, rent, child support, student loans, etc.
- Do not add expenses which cannot be considered as debts, e.g. utilities, gas, taxes groceries, childcare, etc.
- Divide this sum by your gross monthly income (monthly income before taxes).
- Multiply the result (usually a decimal number) by 100 to get your final DTI percentage.
The smaller your DTI ratio, the better chances you have of getting the loan approved. This means that the individual is financially stable and therefore is a desirable candidate for the mortgage loan. On the other hand, with a high DTI score, this is a sign of an individual’s low financial credibility, it reveals that the person has a lot of debt and not enough income to cover their expenses or repay the loan.
Naturally, debtors with lower DTI ratios can manage their debt payments better than those who have a high mortgage debt ratio. Ideally, creditors favor a debt-to-income ratio that is lower than 36%. And even in that, not more than 28% of DTI should be devoted to a mortgage or rent. Also, the highest DTI ratio that banks tolerate for a mortgage is usually set at 43%.
Types of DTI
As mentioned earlier, there are two types of DTIs that we had touched upon earlier, front and back ratios. Let us see what they are and what all it entails in detail below;
The front-end ratio can also be called your housing ratio. The housing ratio only uses your house payment, including tax and insurance.
Backend ratios are also called total debt ratio. This ratio includes other debt listed on your credit report plus your house payment, divided by your gross income. It specifies the amount from a person’s income which is used to pay off debts. A low back ratio automatically enhances one’s chances of getting the loan approved. To calculate the back ratio, the bank first considers the summation of monthly debt such as credit card expenses and other additional loans. Lenders usually apply this ratio not in isolation but in combination with front-end ratios, to make an informed decision about the applicant’s DTI score. Generally, banks don’t lend money to people who have a backend ratio of more than 36 percent.
Does DTI Indicate Solid Financial Status?
DTI is a determinant of how well one’s income and expenses are balanced out, however, it is not a judge of a person’s financial status. This ratio is not a substitution for domestic cash flow. This is because, DTI excludes most of the comprehensive expense areas, such as utilities, insurance, and food, debt-to-income and takes into accounts only those expenses which directly or indirectly affect the credit report of the applicant. It is, therefore, an incomplete picture of a person’s finances. It is at best a good indicator of a person’s creditworthiness. A few cost-cutting measures and a meager budget can work wonders in lowering a person’s DTI score and increase the credit potential in the market. DTI is but a general indicator of a person’s financial goodwill, a creation based on which lenders decide if an applicant of getting the loan or not.
Tips to Lower Your DTI
As discussed earlier, having a large DTI ratio automatically disqualifies the candidate’s loan application. Banks don’t consider applications where the DTI is Higher than 43%. So, if you have a lot of debt to settle and not enough income, we suggest waiting for a while, and take these measures to ensure that your DTI lowers considerably;
- Avoid taking more debt than what you already have.
- Cut down on your expenses, refrain from making any big purchases.
- Reduce your spending and pay to avoid using credit cards.
- Increase your monthly income by taking up freelancing jobs and part-time employment.
- Try to pay off your current debts, before applying for new ones,
- Look for alternative income opportunities and sources to widen the money inflow in the household.
Don’t worry if you have a low credit score or a DTI ratio, resilience and smart financial planning can get you out of the situation quickly. Stick to these measures and we’re sure you will be eligible for a mortgage loan in no time.
Conclusion on How is Debt Ratio Calculated for a Mortgage?
It’s difficult to manage expenses due to the ever-inflating prices and increasing lifestyle changes. Everyone wants a loan for something, some need student loans to complete their education, others to start their business, pay medical bills, etc. It is very important to maintain a good credit score and a low DTI ratio if you want financial help from the banks.
 Reed, D. (2018). Mortgages 101, American Management Association