Let’s wear the lender’s shoes for a moment
Say you are someone who has a lot of money and is in the lending business. The goal is to earn interest on your capital and to keep your money safe.
What is your biggest concern when making that decision? The biggest concern you as a lender will have is not being paid that interest and not being returned your money.
In the lending world, we call that the borrower’s ATR. Or Ability-To-Repay. If the borrower has the ability to repay, your objective as a lender is met.
So at its core, what ATR analysis entails is an assessment of how likely the borrower is to fulfill those obligations. And the Debt-To-Income ratio (DTI) is one of the key metrics lenders use to assess that ability.
We’ll quickly define DTI first
In simple words, DTI is the sum of all monthly debt payments you make divided by your monthly gross income from all sources. It is expressed as a percentage number and the lower it is, the higher the chance for you qualifying for a mortgage.
And why is that of interest to a lender?
If your concern is that the borrower may not be able to pay the monthly interest and the principal, you’ll look for those who are more likely to pay back than not.
One good way is to see what an individual’s income is.
For example, say someone makes $10,000 a month. If their monthly mortgage payment is $2,000 and that’s the only debt they have, their DTI ratio will be 2000/10000 = 20%
On the other hand, if their debt payment is $8,000 with the same income, their DTI ratio will be 80%.
Which one of these is more likely to make their payments? The former, I would guess.
Why? Because someone whose debt payment is low compared to their income, has more cushion to work with. They have more disposable income and savings very likely. Hence, they will be more likely to make the payment. They’ll also possibly have more savings.
On the other hand, someone who spends 80% of their income towards debt payments likely has less in savings because most of their income was being used up to make those debt payments.
Two Types of DTI: Front-end & Back-end
There are two types of DTI lenders typically look at:
(1) Front-End DTI – This is the ratio of all your ‘housing-related’ payments to your income. This includes the principal, interest, property taxes and insurance for your primary home.
(2) Back-End DTI – This is the ratio of all your debt payments (housing, auto, credit cards, education) to your income.
Why two DTI-ratios?
The first one is important because it shows how much money you spend on housing and shelter. Everyone needs one and it is a big fraction of everyone’s monthly expense. If it’s too high, you’ll be left with less for other expenses that are necessary for livelihood. And therefore, less for mortgage payments too.
The second ratio is important because even if your housing expense is not that high, you might have a lot of other obligations such as credit card debt, auto loans etc. The more the debt as a percentage of your income, the more risk you pose to the lender.