Understanding the Debt to Income Ratio and Why It Matters

Posted by Shawn Clayton on Friday, April 21st, 2017 at 9:58am.

Financial Ratios for Loans Prospective buyers preparing to purchase a home in Bay Head or surrounding areas sometimes focus solely on whether they can fit the payment into their monthly budget and scrape up enough cash to cover a small down payment and closing costs. But even when there seems to be enough available cash in the budget to meet a monthly mortgage payment of that oceanfront dream home, there can also be a serious debt-to-income issue capable of killing the joy of owning a home. 

To understand how this relates to your specific home buying situation, speak with your lender and/or a financial advisor.

Understanding Debt-to-Income

Basically defined as the portion of the monthly household income that is assigned to meeting debt payments, most financial gurus suggest that the debt-to-income ratio be 36% or lower, in most cases. 

Debts like car notes, credit cards, and loan payments all fall under the debt-to-income category. But it is also important to note that there are some potentially large expenses in every household that are not counted in the debt-to-income ratio. Expenses like utility bills, groceries, gas and other daily living costs can have a significant effect on the buyer's ability to afford the home purchase and successfully meet their monthly mortgage payments. 

Front-end versus back-end

When computing debt-to-income ratios, there are two methods commonly used. The first is called the front-end ratio, sometimes called the household ratio. It consists of the sum of all home-related expenses divided by the household's gross monthly income. For prospective buyers, these costs will include the expected amount of the monthly mortgage payment, property taxes, homeowners association dues, and home insurance premiums. 

The other method is the back-end ratio, and the expenses it includes usually paints a clearer picture of the buyer's financial situation. This is because it also includes monthly expenditures for debt, including credit cards and all types of loans. While the back-end ratio provides more financial information, it still does not include monthly expenses, such as utilities and other necessities that can really add up. 

What lenders consider 

When prospective buyers apply for a home loan, lenders may use either the front- or back-end debt-to-income computation, but most banks, mortgage companies, and online lenders will opt to use the back-end method for conventional loan programs. 

Government-backed loans, however, such as those offered by the Federal Housing Administration (FHA) or the Veterans Administration (VA), usually require the lender to look at both the front-end and back-end ratios. The good news here is that FHA, VA, and other loans of this type often allow higher debt-to-income ratios than more stringent conventional loan programs.

Important takeaways about debt-to-income ratios

Some important things buyers should remember about debt-to-income ratios include:

  • they are figured on pre-tax or gross earnings, so its important to factor in the amount of withholding taxes to get the truest figure
  • keeping debt-to-income ratios low can help to increase credit scores, which may also help to reduce the costs of some types of debt by qualifying for a cheaper interest rate
  • debt-to-income scores can be improved by paying off or down excess debt before starting the home loan application process
  • avoiding new credit purchases and taking out new debt

If prospective buyers compute their debt-to-income ratios and come up with numbers well above 36%, they may want to consider putting off their home purchase for a few months until some of the debt can be paid off. To find out more about debt-to-income ratios and determine whether or not the time is right to purchase a home, prospective buyers should start by consulting with their real estate professional. 

Shawn Clayton, Owner/Broker, REALTORĀ®

Jersey Shores Luxury Home Expert
732-295-2222

Contact Shawn

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