by Robert E Thompson
Here’s the short answer: DTI means Debt To Income. It’s a ratio used in the world of real estate to determine how big of a loan the lender’s willing to make.
A bank looks at three things when providing financing for your home purchase: your Credit, your Collateral, and your Capacity. “The 3 C’s,” as I cleverly call them. While these factors are ultimately all inextricably related, the DTI question is mostly about determining your Capacity, i.e. your ability to repay the loan to the bank – not strangely, this is an important consideration for them. Your DTI tells the lender what percentage of your income you will be spending on debt every month, after the proposed home loan is in place. After they’ve determined this DTI, they will decide if it fits within their guidelines.
Let me start by talking about the two kinds of DTI ratios that lenders consider: the front-end ratio, and… wait for it… the back-end ratio. The front-end ratio is known as your housing ratio, because it simply considers your projected (it’s based on the house you’re planning to buy) monthly housing debt as it relates to your income. The back-end ratio takes these same numbers but also adds your non-housing debt into the equation.
There is not one universal, magic DTI number that banks look for. Different loans and different lenders require different ratios. Some loan programs and lenders may be strict, some less so. For now, we’ll stick with some classic explanations. Your lender can do the fine tuning.
First, let’s deal with the ‘debt’ in DTI. What is the difference between front-end and back-end debt?
Front-end debt is what your projected housing debt will be after you have bought a new home. This housing debt comprises your new loan’s principal and interest payment, your property tax payment, your homeowner’s insurance payment, and your homeowner’s association dues – all broken down to monthly amounts. (Annual numbers will give the same percentages, but credit reports are broken out into monthly payments, so it’s just easier this way.)
For determining your back-end debt, we’re talking about the same monthly housing payments from your front-end ratio plus your recurring monthly debt. Recurring monthly debt might include car payments (and payments from other installment loans, like boats or campers), credit card payments (use the minimum monthly payment shown on the credit report), alimony, child support, student loans. As a loose rule, these debts are those that show up on a credit report. These are added to your monthly housing debt, and the resulting total is your back-end debt. Don’t worry about groceries, trash bills, water bills, et cetera – these are never included.
We’ve now defined what makes up the ‘D’ in DTI. The second important piece of the DTI, the ‘I’, is your Income – your gross monthly income, to be precise. Your gross monthly income is your income before anyone takes anything out – before taxes, social security, etc. Once monthly gross income is determined, the underwriter will divide it by your monthly housing debt to come up with your front-end ratio, and divide it by your total monthly debt to determine your back-end ratio.
So now that we know what all of this DTI is about, you’re undoubtedly worried about what it all means and what ratios are acceptable, anyhow? A classic answer to this might be that the front-end (housing) ratio should be 28% or below with a back-end (all of your debt) ratio of 36% or below. In the old days, that may have been true. But the world of mortgage lending has changed over the years. There are thousands of different loan programs with their own rules as well as thousands of banks with their own rules. The takeaway here is that nothing is written in stone; you must meet the requirements set forth by the lender and each individual loan program. Depending on your unique situation – credit score, down payment amount, assets – banks and loan programs (including conventional loans) will often go quite high with their ratios, sometimes exceeding a 50% back-end ratio.
You now know what the bank will lend you, based on their DTI ratios and other loan parameters. The caveat for you, though, is: just because you qualify for a bigger loan does not mean you should take it. It’s important for you to determine what monthly payment you’re comfortable with, independent of what the bank tells you they can do. Especially if you’re a strong borrower (meaning that you look good on paper), your DTI ratios might stretch further than your actual monthly dollars will – comfortably, anyhow. This is where budgeting comes in – you need to determine what the maximum monthly mortgage payment is that you’re comfortable with. Once you determine this amount, your lender can back in to what your maximum purchase price should be. And once you know that maximum, you have a good number to tell your agent so that she can tailor the search to you.