Your debt-to-income ratio, or debt ratio, is typically represented as the percentage of your income that goes toward paying your debt. A lot of lenders, especially mortgage and auto lenders, use your debt ratio to evaluate your credit worthiness, i.e., how much of a loan you can handle. For example, a mortgage lender will use your debt ratio to figure out the mortgage payment you can afford after your other monthly debts are paid. Debt ratio considerations are as important as your credit score. While your credit score reflects how responsible you are in paying your bills, your debt ratio gives potential creditors additional insight into your personal finances. Your debt ratio shows just how much debt you're juggling as compared to your income. It's possible that someone with a good credit score could be turned down for a mortgage or home loan because lenders feel the borrower is simply carrying too much debt, despite a steady history of on-time payments.

Information Needed To Calculate Debt Ratio

1. Gather recent paycheck stubs. Add up total gross monthly income. If total income varies from month to month, calculate the monthly average for the past two years.
2. Determine the total housing cost, such as mortgage principal and interest or apartment rental, mortgage insurance premium, property tax, homeowner's insurance premium, hazard insurance premium, and any homeowner's association dues.
3. Gather statements from all other monthly recurring bills. This includes revolving debts (the minimum monthly credit card payments listed on the credit report), installment loan payments (including such things as vehicle loan or lease payments and student loan repayments), alimony payments, legal judgments, etc. Any installment debt with fewer than ten payments remaining is not to be counted unless it is a vehicle lease payment; lenders believe another vehicle lease agreement will be signed when the current lease expires.
4. Add the amounts from these other monthly recurring bills to the total monthly housing cost to calculate the total monthly debt obligation. Do not include ongoing living expenses such as groceries, gas, or utilities, as these are not considered debts.

Let's go through an example to demonstrate how to calculate debt ratio. Assume the following monthly financial situation for an applicant: 

• Gross wages of $5,000
• Principal and interest payment of $1,000
• Property tax of $150
• Homeowner's insurance of $65
• Homeowner's association fees of $45
• Total credit card debt of $225
• Vehicle loan payment of $350
• Student loan repayment of $125

Now we are ready to calculate the debt ratios.

There are two different debt ratios which mortgage lenders use when evaluating a borrower for a loan.

Primary Debt Ratio

The primary or front-end ratio is the monthly housing cost divided by gross monthly income.

In this example, the total housing cost is $1,260 ($1,000 + $150 + $65 + $45 = $1,260).

Gross monthly income is $5,000.

The primary or front-end debt ratio is 25.2% ($1,260 / $5,000 = 25.2%).

Secondary Debt Ratio

The secondary or back-end debt ratio is the total of all recurring monthly debt (housing cost plus all other monthly recurring debt) divided by gross monthly income.

In this example, the total recurring monthly debt is $1,960 ($1,260 + $225 + $350 + $125 = $1,960).

The secondary or back-end ratio is 39.2% ($1,960 / $5,000 = 39.2%)

Lenders like these ratios to be low – generally, the lower they are, the greater the chance you will be able to get the loans or credit you seek. Talk to your lending professional about the debt ratio requirements for the type of loan for which you’re applying. If your ratios are higher, you should take action to reduce them.

Finally, lenders have policies in place on how to calculate income, so be sure to speak with your lending professional to determine what monthly income figure they’ll use.

Anyone serious about increasing their credit scores should first take the time to understand how scores are calculated. By doing so, any effort put forth to increase credit scores is maximized. According to Fair Isaac Corporation (FICO), the percentages of importance in determining credit scores are:

1. 35% Payment History
2. 30% Amounts Owed
3. 15% Length of Credit History
4. 10% New Credit
5. 10% Types of Credit Used

Let’s examine each of these categories in more detail to learn more:

Payment History – 35%
In simplest terms, credit that has an on-time payment history is better than credit that’s been past due — we all understand that. However, did you know that an open account that is currently past due is WAY more damaging than an account that has been past due recently but is now current?

An easy way to get a bump in scoring is to get any OPEN accounts that are past due current. However, that doesn’t necessarily mean you want to pay off any open collection accounts. Be sure to speak with your loan officer or credit professional prior to paying off any closed derogatory accounts, since doing so can create documentation issues and actually even decrease your score.

Amounts Owed – 30%
This category is easily the least understood by consumers. Considering the importance (30%) in deriving credit scores, knowing more about how this affects your credit is critical.

The are many different components that make up the “Amounts Owed” category, such as the total debt owed, number of accounts that have a balance, and percentage of credit utilized on revolving accounts. The last one, percentage of credit utilized on revolving accounts, is often times that easiest to manipulate on the consumer’s behalf and therefore can impact scores quickly. To understand more, let’s examine the following scenario:

Consumer A has a $1,000 credit card balance with a $5,000 credit limit. Consumer B has a $1,000 credit card balance with a $1,000 credit limit; all other credit is the same. Which one has a better score? If you guessed A, you would be correct, and the difference would be significant!

Consumer A owes 20% of their limit on this account while Consumer B owes 100%. The scoring models view consumer B as being riskier, given they’re “maxed out” on their credit card. A good rule of thumb is attempt to owe no more than 30% of the limit on any credit card; for example, keep your balance at $300 or less on the card with the $1,000 limit. A good strategy is to continue to pay all bills on time and work with the creditor to increase your credit limits while retaining small balances.

Length of Credit History – 15%
Another straightforward category — the longer you have credit the better your score is and vice versa for shorter credit history.

New Credit – 10%
This category is different from Length of Credit History, as it examines how old (or new) individual accounts are. Older accounts are scored better in comparison to newer accounts. Additionally, new credit inquiries can impact your score negatively if there are an abundance of them. The advice here is to consider keeping open established accounts even if it means retaining a small balance in order to do so.

Types of Credit Used – 10%
Examples of different types of credit include revolving (credit cards), installment, and mortgage accounts. To increase scores, a mix of these accounts normally works best. For example, someone who has only three credit cards accounts would typically have a lower score than someone with a mortgage, installment, and credit card account even if all accounts have the same balance and all are current.

Word of Advice
As always, talk to your loan officer or credit professional PRIOR TO making changes on your credit to ensure you’re making the right choice to increase your credit scores. And remember, you may have to document changes, especially those in which you pay down debt, with proof of how you obtained the funds to make the payment in order to have the improvement in your credit score considered by the lender in the lending decisions.

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.

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.

*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.

Conclusion
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.

Since employees might incur a wide variety of expenses related to their job, this article will cover only the following broad categories of tax-deductible job expenses

• Vehicle expenses
• Parking, tolls, and local transportation expenses
• Travel expenses
• Meals and entertainment expenses
• Other business expenses

For additional information on tax-deductible job expenses, please refer to the IRS website, https://www.irs.gov.

Recordkeeping is particularly important for job-related expenses.  Whether you seek reimbursement from your employer or take a deduction on your personal tax return, the IRS expects business expenses to be adequately substantiated.  Adequate substantiation means that for each expense, you have documents to show the description, the amount, the business purpose and relationship, and the date and place where the expense was incurred.  For general information on recordkeeping, please refer to the IRS website, https://www.irs.gov.

An employee's business expense reimbursement or allowance under a plan that qualifies as an "Accountable Plan" is excluded from the employee's gross income and is not reported on the employee's W-2, i.e., it is tax-free to the employee and tax-deductible to the employer.  In addition, these amounts are not subject to withholding or employment taxes.

In contrast, amounts paid under a "Non-Accountable Plan" are included in the employee's W-2 wages and are deductible as miscellaneous itemized deductions, subject to the 2 percent Adjusted Gross Income (AGI) limitation.  In other words, because of the 2% AGI limitation, only a part of these job-related expenses are deductible.  In addition, deductions may be further limited by the overall limitation on itemized deductions.

While it is generally in the best interest of the taxpayer to maximize deductions, please be aware that in some instances, these deductions may lower your income to the point where your debt-to-income ratio could adversely affect your ability to qualify for a mortgage loan.  

If you are considering qualifying for a mortgage loan, be sure to discuss any employment deductions with your loan officer.

 

The information presented in this article is meant as a general guide.  Before taking action and for specific questions regarding your particular tax situation, please refer to the IRS website, https://www.irs.gov, or consult a tax specialist.

 

In light of August, 2014 changes made to Fannie Mae’s mortgage loan waiting policy for borrowers who have experienced a short sale, we felt it would be useful to review the mortgage loan interval qualifying guidelines following a financial hardship event for the most popular mortgage loan programs.

Please see the table below.

Mortgage Loan Interval Qualifying Guidelines Following Financial Hardship as of January, 2015

¹ If the buyer is able to prove extenuating circumstances, Fannie Mae may qualify the buyer to repurchase using conventional financing after only three years; additional requirements after three years up to seven years:

1. 90% Maximum LTV ratios

2. Purchase for principal residence

3. Limited cash-out refinance for all occupancy types

² If the buyer is able to prove extenuating circumstances, Fannie Mae may qualify the buyer to repurchase using conventional financing after only two years.

³ If the buyer is able to prove extenuating circumstances for the most recent bankruptcy, Fannie Mae may qualify the buyer to repurchase using conventional financing after only three years.

⁴ Exception: The lender may grant an exception to the three-year requirement if the foreclosure or short sale was the result of documented extenuating circumstances that were beyond the control of the borrower, such as a serious illness or death of a wage earner, and the borrower has re-established good credit since the foreclosure.

⁵ Borrower current at the time of short sale: A borrower is considered eligible for a new FHA-insured mortgage if, from the date of loan application for the new mortgage, all mortgage payments on the prior mortgage were made within the month due for the 12-month period preceding the short sale, and installment debt payments for the same time period were also made within the month due.

⁶An elapsed period of less than two years, but not less than twelve months, may be acceptable for an FHA-insured mortgage, if the borrower can show that the bankruptcy was caused by extenuating circumstances beyond his/her control, and has since exhibited a documented ability to manage his/her financial affairs in a responsible manner.

Note: the lender must document that the borrower's current situation indicates that the events which led to the bankruptcy are not likely to recur.

⁷A Chapter 13 bankruptcy does not disqualify a borrower from obtaining an FHA-insured mortgage, provided that the lender documents that one year of the pay-out period under the bankruptcy has elapsed, the borrower’s payment performance has been satisfactory, all required payments have been made on time, and the borrower has received written permission from the bankruptcy court to enter into the mortgage transaction.

Click the following link for additional information: 

https://portal.hud.gov/hudportal/documents/huddoc?id=4155-1_4_secC.pdf

⁸ Foreclosure (and deed in lieu of foreclosure) – Per VA guidelines, in order to meet satisfactory credit risk in the 1-2 year period after a foreclosure, the lender must follow bankruptcy guidelines. Bankruptcy guidelines are: If the bankruptcy was discharged within the last 1 to 2 years, it is probably not possible to determine that the applicant or spouse is a satisfactory credit risk unless both of the following requirements are met:

• The applicant or spouse has obtained consumer items on credit subsequent to the bankruptcy and has satisfactorily made the payments over a continued period, and

• The bankruptcy was caused by circumstances beyond the control of the applicant or spouse such as unemployment, prolonged strikes, medical bills not covered by insurance, and so on, and the circumstances are verified. Divorce is not generally viewed as beyond the control of the borrower and/or spouse

If the bankruptcy was caused by failure of the business of a self-employed applicant, it may be possible to determine that the applicant is a satisfactory credit risk if:

• The applicant obtained a permanent position after the business failed, and

• There is no derogatory credit information prior to self-employment, and

• There is no derogatory credit information subsequent to the bankruptcy, and

• Failure of the business was not due to the applicant’s misconduct.

Click the following link for additional information: 

https://www.benefits.va.gov/warms/pam26_7.asp

⁹ Adverse credit waivers may be granted for USDA buyers if there were mitigating factors beyond the buyer’s control and those factors are documented and have been removed.

As an example, if the circumstances causing the adverse credit were beyond the applicant’s control and temporary in nature, such as increased expenses due to illness and/or medical expenses, injury, death, etc., and those circumstances are no longer a factor, there may be justification for an adverse credit waiver.

Click the following link for additional information:

https://www.rurdev.usda.gov/supportdocuments/ca-sfh-grhunderwritingguide.pdf

Regardless of their former financial situation, it is important for those looking to re-enter the housing market to re-establish their credit again as quickly as possible following their hardship. They should start by obtaining a copy of their credit report, then contact a mortgage professional for guidance in rebuilding their credit score and to obtain additional information for help in determining their eligibility for a mortgage loan.