Down Payment, Debt Ratio, and Private Mortgage Insurance

*Disclaimer – Loan guidelines change often and may have recently changed; be sure to consult with your lender about current requirements.

Two Ratios – Front End and Back End
Lenders use two types of debt ratios in determining a person’s ability to qualify for a mortgage. The front end ratio is real estate-related debt (mortgage principal and interest, real estate taxes, real estate insurance) divided by gross income. The back end ratio is real estate-related debt plus other liabilities listed on your credit report divided by gross income. Therefore, a person’s front end and back end debt ratios would be the same if there is no additional debt listed on the credit report. However, since most people have additional debt listed on their credit report, most borrowers have a higher back end ratio.

The important thing to understand about the two ratios is that lenders not only look at the total (back end) debt ratio, but they also use the front end ratio to examine the impact of the new real estate debt.

Example – Debt Ratios
Let’s assume a person who applies for a mortgage makes $60,000 a year gross (or $5,000 a month) income. The new mortgage debt including principal and interest, taxes, insurance (both home and mortgage insurance) totals $1,500 a month. Their other debt, including a car loan and two revolving charge accounts totals $750 a month. Their ratios are:

Front End Ratio: $1,500/$5,000 = 30%
Back End Ratio: $2,250/$5,000 = 45%

Max Debt Ratios Allowed? – Not a Given
The first thing to understand about today’s mortgage environment is that the vast majority of loans are reviewed by an automated underwriting system. Neither conventional nor FHA is set up to auto-approve someone based on a single debt ratio limit. Instead, the system takes into account other factors such as down payment, credit scores, and assets in determining whether the borrower’s debt ratios are permissible. For example, someone with a higher credit score may very well be allowed to have a higher debt ratio in comparison to someone with a lower score.

Conventional versus FHA – Debt Ratio Maximum
Conventional back end ratio limits normally top out at 45%, although on occasion an approval will go as high as 50%. FHA’s system will go as high as 56.99% for a back end ratio for more qualified borrowers. However, it’s crucial to point out that many lenders have pre-defined limits that are lower than what the system allows. For example, many lenders won’t lend to anyone who has a back end ratio higher than 45%, regardless of whether the system indicates they’re approved to go higher.

If your debt ratio is holding you back from qualifying, take the time to learn what your ratios are and determine exactly how far away you are from qualifying. Something simple, such as a small raise or a small reduction in purchase price may lower your debt ratio enough to purchase now rather than later.