Debt service ratio, also called total debt ratio, plays an important role when you apply for a mortgage. Lenders evaluate your ability to repay a loan before approving it, a process called underwriting. Their main concern is whether you will make all your payments on time and in full.
If you are a creditworthy borrower, you may receive better loan terms, such as a lower interest rate. However, if lenders judge you to be financially risky, then your access to credit, or at least cheap credit, may be reduced. The debt service ratio is one of the metrics lenders use evaluate your creditworthiness.
Components of Debt Service Ratio
The debt service ratio consists of your:
- Mortgage payments
- Property taxes
- HOA fees
- Homeowner’s and mortgage insurance
- Credit card balances
- Outstanding loans
Debt Service Ratio Formula
The formula for the debt service ratio is
Debt Service Ratio = (AMP + PT + ODP) / Gross Family Income
The following definitions apply to the formula:
- AMP: Annual mortgage payments.
- PT: Property taxes.
- ODP: Other debt payments. These include credit card balances, child support, student loans, vehicle loans and any other debts, as well as the other housing costs.
- GFI: Gross family income, which is the amount of money your family earns before deductions for taxes and retirement plans.
Front-End Debt to Income Ratio
The debt service ratio is also known as the back-end debt-to-income ratio (DTI) and includes all debt and fixed housing payments. The front-end DTI ratio considers only your fixed anticipated housing costs, including mortgage/rent, HOA, property taxes, homeowner’s insurance and mortgage insurance. Front-end DTI excludes you credit card balances and any other non-housing debts.
Example Ratio Calculation
Imagine you are a head of household who earns $10,000/month of gross family income. You face the following payment obligations each month:
- Mortgage payments: $2,100
- Property taxes: $50
- Mortgage and homeowner’s insurance: $250
- Education loans: $800
- Car loan: $300
- Credit card balance: $800
The total of your monthly debt payments is $4,300. Plug that into the debt service ratio equation and you get $4,300/$10,000, or 43 percent. The front-end ratio, which excludes the last three expenses, is $2,400/$10,000, or 24 percent.
Benchmarks for Debt Service Ratio
Lenders use certain benchmark values to assess your front- and back-end debt service ratios. Typically, lenders need to see a back-end ratio below 43 percent, and preferably no higher than 36 percent. The preferred range for the front-end ratios top out at 28 to 31 percent.
Lenders vary in how strictly they adhere to debt service benchmarks. For one thing, these are only one of several metrics that underwriters use to evaluate creditworthiness. Additionally, different lenders have varying degrees of flexibility when it comes to writing loans. For example, a credit union might accept a higher TDS ratio than would a bank. In some cases, the back-end ratio might rise as high as 50 percent.
Debt Service Ratio Mortgage
One important type of conventional home mortgage is a loan guaranteed by the Federal Housing Administration. These mortgages are popular for first-time homeowners because they require a small down payment (3.5 percent) and a minimum credit score of only 580. The FHA mortgage is really a debt service ratio mortgage because of set limits on the front- and back-end ratios.
As of 2019, those limits are 31 percent for front-end ratios and 43 percent for back-end ratios. This compares to 28/36 percent for average non-FHA conventional mortgages, 29/41 percent for U.S. Department of Agriculture mortgages, and a back-end ratio of 41 percent for Veterans Affairs mortgages. Nonconforming jumbo mortgages typically have a maximum back-end ratio of 43 percent.
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