Knowing how many financial obligations you are currently paying and how much more you can handle is a creditor’s primary concern. Your debt-to-earnings ratio -- or debt-to-income-ratio -- allows you to measure the relationship between your income and debts. Understanding this tool can help you recognize your chances of acquiring a loan.
The debt-to-income ratio (DTI) is a financial analysis tool commonly used by creditors to measure the percentage of your income that goes toward paying your debts. This measure is important to lenders because it allows them to gauge the probability that the borrower will repay the loan. Creditors may establish different acceptable DTI ratios, which is why it’s better to inquire about such ratios before submitting a loan application.
The front-end ratio indicates the percentage of income that goes toward housing costs. The housing cost paid by renters pertains to monthly rental. Homeowners housing cost includes mortgage principal and interest, mortgage insurance premium, hazard insurance premium, homeowners' association dues, and property taxes. Multiplying your average monthly income by the ratio set by your lender gives you the amount that you can use for housing costs.
The back-end debt-to-income ratio indicates the percentage of income that goes toward paying all recurring debt payments, including those covered by the front-end ratio. Recurring debt payments include those made toward credit card balances, car loans, student loans, child support, alimony and legal judgments. Utility bills, car and health insurance, cell phone bills, and bills not reflected on your credit report are generally not considered recurring debt payments.
For example, assume that your average monthly income is $3,500 and that the lender has established a maximum monthly debt-to-income ratio of 31 percent/43 percent. This means that to qualify for a mortgage, your front-end debt-to-income ratio should be no higher than 31 percent while your back-end ratio should be no higher than 43 percent. Multiplying your average monthly income of $3,500 by 0 .31 will give you a front-end figure of $1,085. Multiplying $3,500 by 0.43 will give you a back-end figure of $1,505. In this situation, you would meet the det-to-income ratio requirement, but just barely. If you made less than $3,500 a month, or if your collective debt were any higher, you would not qualify for the loan without special consideration by the lender.
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