Debt ratio calculations aren’t as complicated as they seem. You only include the debts on your credit report. Of course, there are exceptions to every rule. Read on to learn about debt ratios and what you should expect to include in yours when applying for a mortgage.
What is a Debt Ratio?
The debt-to-income ratio is the measurement of your outstanding debts compared to your total income. It helps lenders determine how likely you are to pay the mortgage loan back. Each lender and loan program has its own debt ratio requirements. Generally, you’ll find DTI requirements to be between 28 and 43%. It depends on the type of ratios you are talking about.
What’s the Difference Between the Front and Back-End Ratios?
You’ll hear lenders talk about two different ratios – the front and back end ratios. The front-end ratio is the comparison of the mortgage payment to your gross monthly income. Your mortgage payment includes principal, interest, taxes, and insurance. This includes PMI or MI if you owe it. The following front-end ratio maximums apply to the various loan programs:
- Conventional – 28% maximum
- FHA – 31% maximum
- USDA – 29% maximum
The back-end ratio includes your total debts. Not only must you include your mortgage payment, but also your other monthly debts. Think of things you pay like your car payment, student loans, and credit cards. Lenders use the minimum payment for each debt when determining your back-end debt ratio. You may also hear this called the total debt ratio. Just like the front-end ratios, different programs have different back-end ratio maximums allowed:
- Conventional – 36% maximum
- FHA – 36% maximum
- USDA – 41% maximum
- VA – 41% maximum
You may have noticed that the VA doesn’t have a minimum front-end ratio. Technically, they don’t have strict debt ratio requirements. They focus more on the disposable income borrowers have at the end of the month. Any money you have left after you pay your monthly bills is your disposable income. The VA requires a specific amount of disposable income in each area of the country. This is how they help decrease the amount of defaulted loans.
What Debts are Included in the Debt Ratio Calculation?
Now we’ll look at which debts are included in the debt ratio calculation. Luckily, it won’t’ be every debt you have. We’ll discus the exclusions below. For now, let’s focus on what they do include:
- Installment debt – Lenders must include any debt with at least 10 payments remaining. This includes auto and student loans.
- Revolving debt – Lenders use the minimum payment required as stated on the credit report. If the credit report doesn’t show a minimum payment, the lender may use up to 5% of the outstanding balance.
- Personal lines of credit – Lenders treat personal lines of credit the same as credit cards. They use either the minimum required payment or 5% of the outstanding balance.
- Unreimbursed employee expenses – If your income is comprised of more than 25% commission, it affects your DTI. Lenders must look at your tax returns to determine the amount of expenses you that are not reimbursed.
- Alimony/Child Support – Any legal agreements for alimony or child support affect your debt ratio. The lender must include the required amount in your monthly debts.
- Business debts – If you own a business and can’t prove that the company pays the business expenses, it may affect your debt ratio.
- Deferred debt – Even if you don’t currently owe money on your debts, but will in the near future, lenders must include a payment in your DTI.
- Lease payments – Even if you only have a few lease payments left, it must be included in your DTI. Lenders assume it will lead to another lease agreement and affect your DTI.
What Debts are Excluded from the Debt Ratio Calculation?
You must include numerous debts in the debt ratio calculation. But, there are many you don’t have to include. Following are the most common exclusions:
- Cosigned debt – Cosigning on a loan doesn’t mean you are responsible. If you can prove you don’t pay the bill, the lender may not include in your debt ratio. But, you must prove you aren’t the responsible party. You can do this with bank statements from the party paying the bill. They must show timely payments from their own account.
- Voluntary alimony or child support – Only court ordered payments must be included in the debt ratio. If you voluntarily make payments, you don’t have to disclose it to your lender.
- Business debts – If you have ample proof that the company pays your business debts from its own funds, you can exclude it from your debt ratio.
- Wage garnishments with less than 10 months left – Wage garnishments typically affect your debt ratio. But, if you have fewer than 10 payments left, you can disregard it.
- 30-day accounts – Credit cards, such as American Express, that require full payment within 30 days don’t affect your debt ratio.
In addition, you don’t have to include daily living expenses including utilities, food, and clothing. Only debts that report on your credit report matter. However, if you make these payments with a credit card, they will ultimately affect your DTI in the end.
What Significances Does 43% Have in the Debt Ratio?
No matter the requirements each program has, lenders are held to a strict 43% maximum DTI rule. It’s called a Qualified Mortgage. Lenders that lend money to borrowers with a DTI higher than 43% may not have the protection of the QM guidelines. This allows borrowers the ability to take legal action against lenders when they can’t afford their loan payments. Not many lenders are willing to take the chance with a DTI higher than 43%, though.
You may even find different lenders that calculate the DTI differently. It’s always important to shop around and find the best deal. Certain debt ratio calculations are required by specific programs, such as Fannie Mae programs. Others are lender specific and can be worked around by shopping with different lenders. Make sure you find the loan that works the best for you and your financial situation.