You’ve got your down payment. Your credit score is fantastic. You’ve even figured out your monthly budget for housing expenses.
So now you’re ready to charge ahead into the home buying process, right? Maybe not. If you’ve overlooked your debt-to-income ratios, you might not be as mortgage-ready as you thought.
What are they?
As the name suggests, debt-to-income ratios (DTIs), are ways of measuring a person’s monthly debt payments as they relate to incoming cash.
There are two main types of debt-to-income ratios used by mortgage lenders. These are known as the front-end ratio and the back-end ratio. The front-end ratio measures monthly payments for only housing-related expenses, like mortgage principal, interest, taxes, mortgage insurance, homeowner’s insurance and HOA fees (if applicable).
The back-end ratio encompasses all debts that are currently or will be paid on a monthly basis, like the housing-related expenses, home equity loans, credit card minimums, student loans, personal loans, alimony/child support and any other monthly debts.
Remember that your income figures should include not only any salary you receive, but also any alimony or child support taken in, stock dividends, profits from a side business, or regular bonuses (yearly totals divide by 12 for a monthly figure). Be sure to use gross (before tax) figures.
How do I calculate my DTIs?
Once you’ve added up your projected monthly housing expenses, simply divide them by your gross monthly income. This will give you your front-end DTI. For example, if your projected monthly housing expenses are $1,500 and monthly family gross income is $6,000, your front-end DTI is 25%.
To calculate your back-end ratio, just add your monthly debts as described above and then divide them by your gross monthly income.
Why is it so important?
Generally speaking, mortgage lenders want a potential home buyer to have a front-end DTI of no more than 28% and a back-end of 36%. While these numbers may vary from lender-to-lender or by location, it is wise to use these figures as targets when you are beginning the process of buying a home.
If you find yourself with numbers above the 28/36 thresholds, don’t despair. While it may be tough to quickly raise your recurring monthly income, it’s usually easier to examine your budget for ways to free up money to aggressively chop away at your debts. You may need to sacrifice a few luxuries for a while, but if doing so helps you get into a home you love, you will probably find it was all worth it.
For worksheets and tips to help you with your home purchase, you can take advantage of this free Homebuying Handbook.