Debt to Income Ratios, Diving Deeper

debt to income ratiosOf all the important numbers to consider when applying for a home loan, one should be known at the start by homebuyers: your debt to income ratio.

Debt to income ratio, or DTI, is actually two numbers: a front-end ratio and a back-end ratio. These practical, helpful numbers are a dependable guide to helping you understand just how much home you can afford. If calculated and used correctly, debt to income ratios also can save you headaches once you begin paying off that brand new mortgage.

Both the front- and back-end ratios are used by mortgage lenders to help determine whether you'll be able to pay them back each month. But debt to income ratios are also critical for homebuyers to know because they present a simple way to step into the shoes of the lender early in the home-shopping process. They give you quick insight into which houses are within your reach financially. They are reality checks.

What's in the Front-End Ratio?

There are two main types of loans available to most borrowers: conventional loans and FHA loans. Conventional loans typically have conservative thresholds for front- and back-end ratios, while FHA loans will have higher limits.

The front-end ratio, also called the housing expense ratio, is the percentage of your gross (or pretax) income that will go to paying off your mortgage payments each month. While conservative lenders will look to make sure their borrowers don't pay more than 28 percent of their monthly gross income toward their mortgage, other lenders might be willing to push this threshold up to 30 percent and beyond. Of course, in this post-boom era, it's more difficult to find lenders willing to take on borrowers with front-end atios in the upper realms. It's a good idea to check with your lender to see what their desired range is.

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So, for example, if you earn $5,000 per month, and your mortgage lender has a maximum front-end ratio threshold of 28 percent, they would probably be willing to handle a mortgage that requires you to pay no more than $1,400 ($5,000 x 0.28) per month.

What's in the Back-End Ratio?

The back-end ratio, also called the debt-to-income ratio, is the percentage of your gross monthly income that will go toward paying off all of your debt obligations. This includes your mortgage, credit card payments, student loan payments, car payments, child support, etc. Conservative lenders likely will want no more than 36 percent of your monthly gross income going toward your debt obligations, while others may be willing to push this up to 40 percent or more.

So, for example, if you earn $5,000 per month and your monthly non-mortgage debt payments equal $400 (8 percent of your gross monthly income), that's added to your $1,400 in mortgage payments each month, making your debt to income ratio 36 percent ($1,400 + $400 / $5,000). Since this meets the conservative 36-percent threshold, you would probably be a strong candidate for a mortgage.

What Works Now

Brian Dixon, vice president of Perl Mortgage Inc., has seen debt to income ratios trend toward the conservative side of the spectrum in the past year or so. "It was not uncommon only a year ago, where Fannie and Freddie would accept back-end ratios as high as 60 percent -- even higher for strong credit files," he notes. However, agencies are now capping their back-end ratios within the 45 to 50 percent range.

Back-end ratios will settle around 45 percent for conventional loans, according to Dixon, who expects FHA-backed loans to follow suit. Since back-end ratios take into account gross income, this 45-percent mark is "still quite high."

Mary Tootikian, author of "Stunned in America: Sub-Crime Mortgage Crisis" and longtime mortgage underwriter, has observed loans with back-end ratios as high as 48 percent being approved lately, so long as there are "compensating factors," which include sufficient cash in the bank and solid credit scores.

While the bursting of the housing bubble has reduced some questionably high debt to income ratios acceptable to riskier lenders, it doesn't mean that those ratios are no longer accepted. Still, for buyers, the importance of DTI has never been clearer. If your front-end ratio shows you can't make the payments for that dream home, it's time to stop and rethink whether you're ready for something that big. And if your back-end debt to income ratio is rising over 40 percent -- it's time to get your debt under control.

Debt to income ratios can be a harsh master, but understanding the full implications can make all the difference in the world to a homebuyer.
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