Why Debt to Income Matters in Mortgages

Paying your bills on time, having stable income and boasting a good credit score won't get you a mortgage loan if your lender determines that you live too close to the edge.

In the mortgage lending world, your distance from the edge is measured by your debt-to-income ratio, which, simply put, is a comparison of your housing expenses and your monthly debt obligations versus how much you earn.

Knowing your DTI is just as important as knowing your credit score when you get ready to apply for a home loan, says Ed Conarchy, a mortgage planner and investment adviser at Cherry Creek Mortgage in Vernon Hills, Ill.

"People are so focused on their credit scores and on getting a low interest rate that they forget to look at the big picture of their financials," Conarchy says. "Your debt-to-income ratio plays a huge role. It's a number that can impact whether or not you're getting a mortgage in the first place."

How to Figure Debt-to-Income Ratio

There are two types of debt-to-income ratios that lenders look at when you apply for a mortgage:

  • The front-end ratio, also called the housing ratio, shows what percentage of your income would go toward your housing expenses, including your monthly mortgage payment, real estate taxes, homeowner's insurance and association dues.
  • The back-end ratio shows what portion of your income is needed to cover all of your monthly debt obligations. This includes credit card bills, car loans, child support, student loans and any other debt that shows on your credit report that requires monthly payments, plus your mortgage payments and other housing expenses.

To calculate the front-end ratio, add up your expected housing expenses and divide it by how much you earn each month before taxes (your gross monthly income). Multiply the result by 100 and that is your front-end DTI ratio. For instance, if all your housing-related expenses total $1,000 and your monthly income is $3,000, your DTI is 33 percent.

To determine the back-end ratio, add up your monthly debt expenses with your housing expenses and divide the result by your monthly gross income. For instance, suppose you pay $200 per month for a car loan, $50 per month in student loans, and about $100 per month in credit card bills. That adds up to $1,350 in monthly debt obligations, including housing expenses. Based on a monthly income of $3,000, your back-end ratio would be 45 percent.

Recommended Debt-to-Income Ratio

Lenders typically say the ideal front-end ratio should be no more than 28 percent, and the back ratio, including all expenses, should be 36 percent or lower.

In reality, depending on credit score, savings and down payment, lenders accept higher ratios. Limits vary depending on the type of loan.

For conventional loans, most lenders focus on your back-end ratio, says Matt Hackett, underwriting manager at Equity Now in New York.

Although it's not written in stone, most conventional loans require a debt to income of no more than 45 percent, he says, but some lenders will accept ratios as high as 50 percent if the borrower has compensating factors such as a savings account with a balance equal to six months' worth of housing expenses, he says.

"Anything over 50, you would need to have some considerable compensating factors to get approved," Hackett says. "Something like a 50 percent down payment."

FHA Debt-to-Income Ratio

For Federal Housing Administration loans, the recommended debt-to-income limit is 31 percent on the front ratio and 43 percent for the back ratio. But with certain compensating factors, the FHA automated approval system accepts ratios as high as 46.99 for housing expenses and 56.99 for the total back ratio, Hackett says.

"I try to stay away from those," he says. "I don't see how one can make payments when 57 percent of your income is already gone. You have to remember these numbers don't take into account your utilities, cable, phone and all those other expenses."

Ways to Get Around a High DTI

The most obvious and easiest way to lower your debt-to-income ratio is to pay off some of your debt. But most people don't have the money to do so when they are in the process of getting a mortgage, since much of their savings often goes toward the down payment and closing costs.

If you think you can afford the mortgage you plan to get but your DTI is over the limit, a co-signer might help solve your problem.

Borrowers can have a relative co-sign their mortgages on FHA loans. Unlike in conventional loans, FHA co-signers are not required to live in the house with the borrower, but they need to show sufficient income and good credit.

Sometimes a co-signer isn't the answer, Concarchy says.

"Just because you are able to get approved doesn't mean you should get approved," he says. "If your DTI is too high, maybe it's time to take a step back and get your finances together before you commit to a mortgage."