Whenever you take a loan to buy a house or a car, you come across the term “debt-to-income-ratio”. This is an important concept, which relates your debt payments to your gross income. With the help of your debt-to-income ratio (DTI), the lenders try to understand your chances of repaying the loan. Read on to know more.
Back end DTI
Let’s consider an example to understand debt-to-income ratio. Suppose your monthly salary is $10,000 and your monthly debt payment is $6000. In this case, your DTI is 60%, which is far from satisfactory. This type of DTI is termed as “back end DTI”. We often break down back end DTI in order to calculate front end DTI.
Front end DTI
Front end DTI is essentially a part of back end DTI. To calculate front end DTI, you need to divide your monthly housing costs by your monthly income. If you live in a rented accommodation, then your housing costs will be the monthly rent. For house owners, the housing costs include mortgage principal, interest, taxes, home insurance payments etc.
Let’s consider the above example once more. Suppose your monthly housing costs constitute 1/3 (i.e. $2000) of your total debt payments ($6000). In this case, your front end DTI will be 20% (since your income is $10,000).
DTI and loans
Lenders largely depend on DTI to decide whether they will approve the loan or not. DTI is also used to determine the interest rate on the loan. A higher DTI would make it difficult for you to obtain loans on reasonable terms and conditions. This is because a higher DTI points to the fact that you are overburdened with debt payments. Note that a high front end DTI is particularly troublesome because it is indicative of default on loans.
The financial institutions usually have specific DTI requirements to approve loans. While private lenders require pretty low DTI, the government backed FHA loans have relatively easy requirements.
DTI is not the only factor when it comes to qualifying for loans. Other factors like credit score are also considered by the lenders. However, DTI plays an important role to get the loan approved. Therefore, try to maintain a low DTI by increasing your income and reducing your debt.