Understanding Debt-To-Income Ratios

If you’ve ever shopped for a home loan, then you’re probably familiar with these three little letters: DTI. Short for debt-to-income, these ratios – there are two of them: front-end and back-end – can either make your dreams come true or crush your home-buying soul. With so much on the line, it’s important to have a clear idea of what your front- and back-end debt-to-income ratios are before you apply for a home loan.

Why DTI Ratios Matter

When my husband and I bought our first home back in 2006, it was far easier to obtain a home loan. Sure, banks and other financial institutions check out your monthly income and debt, but not with the veracity that many do today. Since the mortgage meltdown, many lenders have made your DTI the end-all and be-all of the mortgage application process; they’ve also changed their DTI requirements.

Most lenders now look for a front-end DTI ratio at or below 33 percent. On the back-end, they want to see a ratio at or below 41 percent. Some lenders go beyond that; they want to see front-end DTI below 28 percent and a back-end ratio below 36 percent. The result? With stricter numbers, it’s harder than ever to qualify for the best rates on a home loan.

Front-End DTI

There are two types of DTI ratios. The first is your front-end debt-to-income. This ratio compares your monthly mortgage costs – including escrow – to your gross monthly income. You can use a home loan calculator to estimate what your monthly mortgage would be on a new home.

For example, say I wanted to buy a $200,000 property, making a 20 percent down payment; that means my home loan will be in the amount of $160,000. We’ll also assume I’ve been able to lock in a fairly competitive 4.25 percent interest rate on a 30-year fixed loan. Factor in $2500 in annual property taxes and another $750 in home insurance and my overall monthly mortgage payment will be about $1,058.

Now, look at my gross monthly income – that’s the amount my husband and I earn pre-tax, pre-health insurance, pre-401(k) contributions. We’ll say it’s $4,500 (it’s not; did you really think I’d tell you exactly how much we earn?).

It’s time to do the math!

$1,058 (est. monthly debt) / $4,500 (gross monthly income) = 23.5 percent

With a front-end DTI ratio of just 23.5 percent, we’d easily qualify for the best rates on a home loan. But say we used that home loan calculator to determine our monthly expenses on a more expensive property – say a $275,000 house. Now, pretend we can’t put down the full 20 percent – maybe just 10 percent – meaning we’re looking at private mortgage insurance. Even with the same interest rate, property tax bill, and homeowner’s insurance tab from our above example, we’re looking at:

$1,595 (est. monthly debt) / $4,500 (gross monthly income) = 35.4 percent

There’s not a lender out there today who is likely to give you a home loan with a front end DTI that high.

Back-End DTI

The second part of the DTI picture – and, some would argue, the more important part – is your back-end ratio. Why is this number more crucial? Because it paints a more complete picture of your overall financial situation. You can still use a home loan calculator to figure out your estimated monthly mortgage payments, but that’s only a part of the equation. You’ll also have to tally your monthly debts on everything from student loans to credit card bills to car payments. For example:

$1,058 monthly mortgage payment$200 monthly car payment$150 monthly student loan payment

In all, those three monthly debts add up to $1,408 in payments. That’s your first number in the back-end ratio. You’ll be dividing that by your gross monthly income:

$1,408 (overall monthly debt) / $4,500 (gross monthly income) = 31.3 percent

In that scenario, your back-end DTI is far below even the target numbers of the strictest lenders, meaning your chances of qualifying for a home loan are strong. But what if we ran the numbers again, this time with the $275,000 home that comes with the $1,595 monthly mortgage payment?

$1,945 (overall monthly debt) / $4,500 (gross monthly income) = 43.2 percent

These days, lenders want to see your back-end DTI below 41 percent – most want to see it below 38 or even 36 percent – meaning it’s unlikely you’ll be approved for the more expensive mortgage.