What is a Debt Ratio?
Your debt-to-income ratio can be a valuable number -- some say as important as your credit score. It's exactly as it sounds: the amount of debt you have compared to your overall income.
A debt-to-income ratio (often abbreviated DTI) is the percentage of a consumer's monthly gross income that goes toward paying debts. Speaking precisely, DTIs often cover more than just debts; they can include certain taxes, fees, and insurance premiums as well. Nevertheless, the term is a set phrase which serves as a convenient, well-understood shorthand in the mortgage industry. There are two main kinds of DTIs, as discussed below.
The first DTI, known as the front-end ratio, indicates the percentage of income that goes toward housing costs, which for renters is the rent amount and for homeowners is PITI (mortgage principal and interest, mortgage insurance premium [when applicable], hazard insurance premium, and homeowners' association dues [when applicable]).
The second DTI, known as the back-end ratio, indicates the percentage of income that goes toward paying all recurring debt payments, including those covered by the first DTI, and other debts such as credit card payments, car loan payments, student loan payments, child support payments, alimony payments, and legal judgments.
History of Debt Ratios
The business of lending and borrowing money has evolved in the post-World-War-II era. It was not until that era that the Federal Housing Administration (FHA) and the Veteran's Administration (VA), through the G.I. Bill, led the creation of a mass market in 30-year, fixed-rate, amortized mortgages.
It was not until the 1970s that the average working person carried a credit card. Thus the typical DTI limit in use in the 1970s was PITI (front-end ratio) of less than 25%, with no set limit for the second (back-end) DTI ratio (the one including credit cards and other payments). In other words, in today's notation, it could be expressed as 25/25, or perhaps more accurately, 25/NA, with the NA limit left to the discretion of lenders on a case-by-case basis.
In the following decades, these limits gradually climbed higher, and the second limit was set (coinciding with the evolution of modern credit scoring as lenders determined through experience how much risk was acceptable. This empirical process continues today.
Sample Calculation
In order to qualify for a mortgage for which the lender requires a front-end debt-to-income ratio of no more than 28% and a back-end ratio of no more than 36%:
- Yearly Gross Income = $60,000 / Divided by 12 = $5,000 per month income.
- Front-End Ratio
- $5,000 Monthly Income x 28% = $1,400 allowed for housing expense.
- Back-End Ratio
- $5,000 Monthly Income x 36% = $1,800 allowed for housing expense plus recurring debt.
- Front-End Ratio
Lenders look at these ratios when they are trying to decide whether to lend you money or extend credit. Low DTIs shows you have a good balance between debt and income. As you might guess, lenders like these number to be low – generally, the lower they are, the greater the chance you will be able to get the loans or credit you seek.
