How Debt to Income Ratio Works

Monday, May 7, 2012

Debt to income ratios give lenders a quick rule of thumb to determine how much you can borrow. They try to keep loans affordable by keeping payments to a modest percentage of your total income. With debt to income ratios, they can quickly figure out a reasonable monthly payment – and use that number to calculate your total loan amount.

Debt to Income Ratio – Housing Expense

Your housing expense ratio is a debt to income ratio measuring the percentage of your income that covers housing payments. Housing payments consist of pretty much everything in your monthly payment – principal, interest, taxes, and insurance (PITI).

Lenders set certain limits on where they want your debt to income ratios. For example, they might say they want your housing expenses to be less than 28% of your gross monthly income.

Example

Assume you earn $3,000 per month (gross, or before taxes), and your lender wants your debt to income ratio to be below 28%

3000 x .28 = 840

Your lender wants you to spend $840 or less per month on housing expenses.

The housing expense ratio is sometimes called the “front” debt to income ratio.

Debt to Income Ratio – Long Term Debt

The long-term debt ratio is a debt to income ratio measuring the percentage of your income that goes towards all debt payments. It includes your housing expenses, along with other debt payments (such as auto loans, credit cards, and other debts).

As with housing expenses, your mortgage lender sets a limit on how high they want your long term debt ratio.

The long term debt ratio is also referred to as the “back” debt to income ratio. Why the terms front and back? Lenders print debt to income ratios with two numbers: 33/38. The 33 (in front) is the housing expense ratio, and the 38 (in back) is the long-term debt ratio.

Improving Debt to Income Ratios

Sometimes, borrowers need to apply jointly to have better debt to income ratios. A married couple will often use both spouses’ incomes (which means that both aren’t legally obligated to repay the debt) when applying for loan.

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