Debt-To-Income (DTI) Ratio and its importance

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.

How much DTI do you need to qualify for a loan?

DTI has to be below a certain threshold for a lender to feel comfortable lending to you, as we highlighted earlier. That threshold is different for different mortgage loans. 

There are three main types of mortgage loans and each has a different DTI requirement:

(1) Conventional Loans: Most of the loans originated in the US fall under this category. These are loans that are backed by Government-Sponsored Enterprises (GSEs) Fannie Mae and Freddie Mac. 

The thresholds for Conventional loans are defined as 28/36, which means 28% limit for the front-end DTI and 36% for back-end DTI and both must be met. 

But these are just legacy limits that apply to manual underwriting. With better credit scores and cash reserves, the back-end ratio can be as high as 45%.

Moreover, for loans underwritten through Fannie Mae’s automated underwriting system, the Desktop Underwriter (DU), that limit is 50%. To see your own scenario, please refer to Fannie Mae's guidelines on DTI

(2) FHA Loans: FHA loans are insured by the Federal Housing Administration (FHA). These loans are especially helpful to borrowers with relatively low credit scores. 

General DTI guidelines for FHA loans is 31/43. But with automated underwriting, these limits can be higher, say as high as 50%. Whether the higher limit is applicable to a borrower depends on his or her specific situation. Based on factors such as bigger down payments, higher credit scores and excess reserves, a higher limit may apply.

(3) VA Loans: VA loans are guaranteed by the United States Department of Veterans Affairs (VA). These are loans offered to veterans.  

The DTI guidelines for VA loans require the back-end DTI ratio to be less than 41%. There is no front-end DTI specification. Although this is a limit for manual underwriting, automated underwriting allows for higher limits, up to say 50%. Like FHA loans, these are subject to higher limits based on factors already discussed under the FHA loans section. 

What is included in the debt payments

The following items are included when calculating debt payments for DTI purposes.

• Principal and Interest payment on subject property
• Homeowners insurance, Property tax, Mortgage insurance, HOA dues on subject property
• Education loans
• Auto loans (or lease payments)
• Credit card payments
• Personal loans
• Alimony & Child support
• Mortgage loans and home equity loans on other properties you own

For credit cards, only the minimum payment is included if you are making your payments on time. If you have a balance that’s overdue, you’ll likely be paying interest on that. In such a case, your full monthly payment will be included.

If you notice carefully, all the payments listed above are typically those that you regularly have to make every month. That does not mean you have to include all expenses you regularly incur every month. The following payments are NOT included in the DTI ratio calculation:

• Utility bills (cell phone, electric, gas, cable, water)
• Car insurance premiums
• Health insurance premiums
• Maid service
• Gardening bills
• Other regular household bills

What about income?

For the purpose of the ‘I’ in DTI, all regular sources of income are used. The lender is typically looking for sources of income that are stable and are reasonably expected to continue. This includes:

• Base salary
• Bonus, overtime, commission, or tip income
• Interest and dividend income
• Rental income
• Self-employment income
• Capital gains income
• Corporate retirement or pension
• Disability income — long-term
• Foster-care income
• Military income
• Part-time job, second job, or seasonal income
• Social Security, VA, or other government retirement or annuity

For people who are self-employed, two years of tax returns are used to calculate average monthly income. 

What if I am not sure if I’ll qualify?

Although our goal was to be comprehensive in covering the topic of DTI above, there are still situations where you might have questions. Please call us or email us for any questions or if you’d like to discuss your specific situation.