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Debt to Income Ratio in Detail
There are two kinds of debt to income ratio and it is important to know how it's calculated prior to applying for a mortgage or other large purchase. There are typical limits established, so you will be able to calculate prior to applying.
The first kind of debt to income ratio is referred to as a front-end ratio, which is the percentage of income that goes purely towards housing costs. This includes the amount of rent a person pays if they rent an apartment, house or condo. For homeowners, it is their full mortgage payment, including principal, interest, insurance premium, homeowner's dues if they apply, as well as property taxes.
Most mortgage and finance companies use the front-end ratio to determine what you can afford as far as a mortgage payment. The Federal Housing Association (FHA) has limits of 31/43.
The second kind of debt to income ratio is referred to as a back-end ratio. This is the percentage of income that goes towards paying all of the recurring debt including the housing of the first DTI as well as other debt including child support, alimony, student loads, car loans, and credit card payments.
Calculating Your DTI
If the FHA is giving you limits of 31/43 and you make an annual income of $50,000, your mortgage payments would potentially be calculated as follows.
- $50,000 salary / 12 months = $4167 per month (rounded up)
- $4167 monthly income x 0.31 = $1291.77 (front-end DTI)
- $4167 monthly income x 0.43 = $1791.81 (back-end DTI)
This means that you would qualify for a mortgage of the above amounts, broken down monthly. The second calculation would be your monthly payment plus your recurring debt. Any home that would require a higher monthly payment and you simply wouldn't qualify because the monthly payment exceeds your means. It is common for people to be able to meet the first one and not meet the second one. This just means that you make enough money to afford the mortgage but have too much debt.
So, using the example in the calculations, you would have an extra 12% of your income allowed to go towards "other" debt excluding your home. In addition, these calculations don't consider any other costs that may be incurred monthly including utilities, groceries, day care costs or anything of that nature because they're not considered debt.
In today's economy, some companies are leaving the back-end ratio much higher (as much as 55) or even as an NA. NA means that it's up to the lender to look at a case by case scenario to determine approval or not. Each lender has a different ratio, so it's important to shop around and see what each has to offer. FHA and VA are a little different because the VA takes into account military activity and so they soften the ratio to help.
When a lender is determining whether a person is qualified for a loan, they will check the DTI to make sure a person is capable of paying the loan back based upon their other credit and debt obligations. Without checking, a person could easily become overextended and be unable to pay back the loan. The lender would then be out that money and have to spend additional costs for foreclosure or repossession.
Calculating your DTI before making a mortgage application because it will determine whether you could qualify or not. It will save you a lot of time and allow you to make adjustments prior to sitting down with the finance people. So when you do sit down to process a mortgage application, you'll be ready and, when complete, be walking out with keys to a new home... instead of empty-handed.
If your debt to income ratio doesn't measure up in the front-end, you'll either have to look for a less expensive home or increase your annual salary with a raise or additional income. If it's on the back-end, you will need to reduce your monthly debt. This can be achieved by paying down your credit cards, consolidating student loans, or re-financing your car for a lower payment.
The more debt a person has, the more a person needs to be able to make in order to qualify for certain things. Since the FHA, VA and others all have an established required ratio, the only way in which to qualify if an annual salary isn't high enough is to pay off some debt first.
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