What is Debt-to-Income Ratio?
When people plan to buy a home, they often start by figuring out how much they can afford. The amount a borrower can get in a mortgage depends on the ratio of their debt to income. Most lenders set limits on the amount of monthly payments a home buyer can have in debt. There are two ways the DTI ratio can affect people's buying power, and both are important to understand. This information shows Corona home buyers what they can expect from this part of the mortgage process.
1. How Does the Debt-to-Income Ratio Work?
Although the DTI ratio plays a significant part in an applicant's mortgage approval, it is fairly simple to calculate. To get this percentage, borrowers need to divide their total monthly debt payments by their total monthly income. For example, someone who earns $4,000 per month and has $800 in monthly debts would have a DTI ratio of 20 percent. Lenders set a maximum on the DTI ratio that specific borrowers can have. This number may depend on the applicant's credit score, down payment, and assets in reserve.
2. What Are Front-End and Back-End Ratios?
There are two ratios lenders consider for this part of the process, commonly called the front-end and back-end DTI ratios. The front-end considers the housing payment only, including principal, interest, taxes, and insurance. Typically, lenders want this ratio to be 28 percent or less. In some cases, they may allow a higher percentage. The back-end ratio takes all debts into consideration, such as:
- student loans
- credit card payments
- car loans
- alimony or child support
The maximum back-end ratio varies depending on the loan. It could be as low as 36 percent or as high as 50 percent.
3. How Can DTI Affect Home Buyers?
The harder part of DTI for home buyers is understanding how it affects their buying power. When buyers are interested in purchasing property, they often apply to a lender to get a sense for what they can qualify for. The lender looks at the buyer's income, debts, and credit and chooses an interest rate they think the buyer could secure based on the market and their application. This may vary from one lender to another.
Lenders take this hypothetical interest rate and compare it to property taxes and insurance rates for the area. This provides a maximum monthly payment the buyer can support. Depending on the borrower's debts, they may be capped by the front-end or the back-end ratio. The maximum monthly payment yields a maximum loan amount the buyer could likely get. Of course, the number may change if the interest rates go up or down, or if the buyer adds more debts.
4. Why Is DTI Important for a Mortgage Application?
Since DTI is reasonably easy for buyers to calculate on their own, it can be a useful tool for them to use in planning to buy a home. DTI is a snapshot of a buyer's finances as they are at the time of the application. This means buyers who wait to apply for a loan until they have paid off some debts may be able to qualify for a larger loan. Conversely, buyers who know they need to make major purchases may want to time buying a home carefully. Adding significant debts to a borrower's profile during the buying process can affect how much the buyer can get in a loan, or even if they can get the loan at all.
The DTI ratio may be one of the biggest determiners of a person's home buying power. By understanding how it works, buyers can better prepare for the mortgage loan process.