How to calculate debt to income ratio

What is debt to income?

Balance ScaleDebt to income is a simple formula used by lenders to determine the maximum monthly loan payment. The term debt to income may sound strange and complicated because of the word order. So here’s a simple explanation of debt to income.

The lender adds up the “monthly” debt payments (i.e. credit cards, car payment(s), school loan(s), installment loan payments and other obligations and divides the total amount of monthly credit payments by the monthly gross income. The result of the division is the debt to income ratio.

The lender makes two calculations, the payment calculation is called the "front end" calculation. The lender divides the proposed loan payment by the "gross" monthly income. The second calculation is known as the "back end" ratio. The debt ratio is the total monthly obligations with the proposed loan payment. The proposed monthly payment includes the real estate tax, homeowners insurance, and any other required monthly payment (i.e. flood insurance, earthquake, homeowners association fee, etc.)

Debt to Income Ratio Calculation
Gross monthly income$6,000
Monthly Payments:Front end ratio Back end ratio
Proposed Mortgage payment $800.00 $800.00
Car payment- 0 - $250.00
Minimum credit card payments- 0 - $200.00
School loans- 0 - $1,000.00
Installment loan- 0 - $50.00
TOTAL $800.00 $2,300
Debt to income calculation $800 / $6,000$2,300 / $6,000
Debt ratio13.33% 38.33%

Each loan program has it's own "ideal" debt to income ratio.

The four popular home loan programs, FHA, VA, USDA and conventional mortgages approach the debt to income ratio differently

The debt to income ratios can be greater than the maximum debt to income ratios with the automated underwriting systems. You may be surprised to learn that computer programs make the initial approval decisions on behalf of the lender.
Read more about automated underwriting


FHA debt to income ratio

FHA logoThe ideal debt to income ratio for an FHA loan is 31%/43% for credit scores 580 and above. The mortgage payment should be no greater than 31% of the borrower's gross monthly income and with monthly debt (i.e. car payment, student loans, charge cards, etc.) at 43%. However, the FHA will permit the borrower to go as high as 40% for the monthly mortgage payment and with monthly debt at 50%. There are strings attached.
Read more about the FHA debt to income requirements

VA home loan debt to income ratio

VA logoThe Veterans Administration does not have a front end payment ratio, only a debt ratio. The "ideal" debt to income ratio is 41%. Once again, the back end ratio is the proposed mortgage payment and monthly debt requirements. However, if the borrower does not have any monthly debt, the monthly payment could go as high as 41%. But there's a catch. The VA also uses a calculation called "residual income".

The residual income calculation backs out federal, state, local taxes, the proposed mortgage payment, and all other monthly obligations such as student loans, car payments, credit cards, etc., from the monthly paycheck(s). Also included in the residual analysis is the cost for maintenance & utilities. The number of occupants also affects the calculation. The goal of this estimate is to determine whether there is sufficient money left over to pay for groceries and other living expenses. VA residual income calculator.

VA’s debt-to-income ratio is a ratio of total monthly debt payments (housing expense, installment debts, and so on) to gross monthly income. It is a guide and, as an underwriting factor, it is secondary to the residual income".
Source: VA Pamphlet 26-7, Revised Chapter 4: Credit Underwriting

Conventional home loan debt to income ratio

Fannie Mae and Freddie Mac graphicThe FHA, VA, and USDA home loans are backed by the Federal government. The conventional mortgages are loans that are sold to either the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation. Theses loans do not require upfront mortgage insurance and are identified as loans with down payments of 5, 10, 15 or 20 percent (or more); although Fannie Mae does offer a 3% down payment loan called Conventional 97 for first time home buyers.

The conventional loan traditionally requires a payment ratio of 28%, however, upon searching the Fannie Mae Single Family selling guide, published on August 07, 2018, I was unable to find any reference to a payment ratio expectation. The Fannie Mae guidelines call for a 36% debt to income ratio for manually underwritten loans, however, Fannie Mae (and presumably Freddie Mac), will permit a debt ratio as high as 45% if the borrower meets the credit score and reserve requirements.

USDA debt to income ratio

USDA logoThe USDA loan payment should be at or below 29% of the borrower's monthly gross income and the debt ratio should be 41% or less.

How do I improve my debt to income ratio?

1. The simplest way to lower your debt to income numbers is to earn more money. More monthly income means you have more margin with the payment and debt ratio. Waiting until your monthly income increases will lower the ratio numbers. 

2. Reduce your monthly debt. Pay down your credit cards, installment loans, etc., but be careful, because if you use your savings to pay down your credit cards and other obligations, you may not have enough cash to purchase a home. Another consideration is the effect on your credit score. Paying down debt is ok, but paying off your monthly bills can actually lower your credit score. Only extinguish your monthly debt after speaking to a mortgage loan officer.

3. Reduce the balance on your credit cards and other bills. The loan programs often ignore monthly debt if the number of payments remaining is less than 6 to 10 months, based on the mortgage program. Again, speak to a loan officer regarding the pay down on monthly debt.  

4. Refinance your student loan payment, credit cards, etc. 

5. Reduce your monthly mortgage payment by seeking a lower interest rate. For example, if the seller is willing to pay some of your closing costs, you can use the savings to "buy" discount points to lower the interest rate and consequently the monthly payment.

Student loan payments and debt to income

The lender will use the student loan payment when calculating the debt to income ratio, however, if the student loan is deferred, and an estimated payment is not available, the lender will "estimate" the student loan payment. The monthly student loan payment will be estimated at 1% of the deferred balance. For example, if the deferred loan balance is $50,000, the lender will use $500 as an estimated payment for debt to income purposes.