What is a Debt-to-Income Ratio?
If you or someone you know is struggling with debt, there's a good chance you have heard of a debt-to-income ratio. A debt-to-income ratio, or a DTI, is the percentage of an individual's monthly gross income that goes toward paying debts. It is important to note that DTIs cover more than just debts - they can include the principal, taxes, and fees of any type of loan, as well as other payments such as insurance premiums. With so many expenses facing the majority of consumers, a debt-to-income ratio is divided into two different types - the front-end ratio and the back-end ratio.
The first DTI, commonly called the front-end ratio, refers to the percentage of your income that covers housing costs. If you current rent an apartment, the front-end ratio would include the amount of rent you owe. If you own a home, the front-end ratio would include your mortgage principal and interest, property taxes, and if it applies, your mortgage insurance premium, homeowners insurance premium, and homeowners association dues.
The second DTI, most often referred to as the back-end ratio, includes the percentage of your income that goes toward paying all other routine debt payments, as well as those covered by the front-end ratio. There are several different sources of debt, but most stem from loans you are in the process of paying off or purchases you have made using your credit card. As a result, back-end ratio includes student loan, car loan, and credit card payments. In addition, any type of legally-sanctioned payment such as child support or alimony is part of the back-end ratio.
When you are applying for a loan, such as a mortgage, the lender typically requires a certain debt-to-income ratio to determine whether you qualify, as well as your expense levels throughout the course of your payment plan. For example, a lender may require a debt-to-income ratio of 25/33, with 25% of your monthly gross income covering the front-end ratio and 33% of your monthly gross income covering the back-end ratio. If your gross monthly income is $4,200, $1,050 would be allowed to cover the cost of housing expenses and $1,386 would be allowed to cover the cost of housing expenses plus any recurring debt.
Shift in DTI Limits
For qualifying borrowers, DTI limits are set by the government and can shift due to changes in the economic landscape. For instance, in the 2000s, the real estate bubble contributed to looser credit and the back-end ratio increased. Many people who were probably not supposed to be approved for a mortgage received financing - eventually leading to the subprime mortgage crisis. After the crisis, credit tightened and many borrowers saw the DTI shift downward, thereby making it harder to get a loan. In general, by understanding the ins and outs of a debt-to-income ratio, you will have a better grasp on the ways in which your outstanding payments affect your borrowing opportunities and your overall financial outlook.