How to calculate debt to income ratio for buying a home

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.

EXAMPLE: Jack and Jill have a gross annual income of $72,000 ($6,000 per month) and their monthly bills total $1,500. Now we’ll divide the monthly payments by the gross monthly income and we have a “debt to income” ratio of 25%. Said another way, the total amount of debt Jack and Jill pay each month is 25% of their gross monthly income.

Gross monthly income $6,000
Monthly Payments: 
Car payment $250
Minimum credit card payments$200
School loans $1,000
Installment loan$50
TOTAL Monthly Debt$1,500
Debt ratio1,500 / 6,000 = 25%

That’s simple enough, but the lender will then add in the proposed mortgage payment to their monthly bills.

The proposed mortgage payment includes the loan payment (principal and interest), 1/12 of the annual real estate taxes, 1/12 of the annual homeowners insurance, monthly mortgage insurance premium (if applicable), flood, earthquake or any other required monthly payments required by the lender.

Gross monthly income $6,000
Monthly Payments: 
Car payment $250
Minimum credit card payments$200
School loans $1,000
Installment loan$50
TOTAL Monthly Debt$2,300
Debt ratio2,300 / 6,000 = 38%

As you can see, the debt income ratio increases to 38% after adding in the monthly mortgage payment. This calculation is called the "back end ratio". Lenders use one more calculation to estimate the maximum mortgage payment, called the "front end ratio".

In the previous example we assumed that Jack and Jill had monthly bills totaling $1,500, but what if Jack and Jill did not have any bills whatsoever. Jack and Jill were completely debt free. This is where the front end ratio comes in. The lender will divide the proposed monthly mortgage payment by the monthly income.

Gross Monthly Income $6,000
Mortgage Payment $800
Debt ratio (front end)800/6,000 = 13%

Debt to income is a comparison between the gross monthly income and the monthly debt payments, if any, including the proposed mortgage payment.

What is the best debt to income ratio?

Lower debt to income numbers are better than high numbers. The lender will do flips if the monthly debt ratio is zero or under 36% (back end ratio); and under 28% if there is no monthly debt (front end ratio). Low ratio numbers mean that there is plenty of cash to pay the mortgage payment. If the debt ratio is too high, the borrower might not have enough money to pay the mortgage payment if the monthly bills get too high.

Each loan program has it's own "ideal" debt to income ratio. the "ideal" FHA and USDA loan ratio is 41% with monthly debt (back end ratio) and 29% for the mortgage payment with no or little monthly debt (front end ratio). Conventional mortgages come in at 32% with mortgage payment only and 36% with the mortgage payment and monthly debt. The Veterans Administration does not require a front end ratio, only a debt ratio or 41%. There is some flexibility with the debt ratio. A few percentage points greater than the ideal debt ratio is acceptable with a good credit history and credit score.

In this example, you will notice that the monthly loan payment is well under the acceptable payment ratio (front end ratio), but the back end ratio, exceeds the ratio for both FHA, USDA, VA and conventional financing.

Gross monthly income$6,000  Gross monthly income $6,000
Mortgage Payment $800  Mortgage Payment $800
   Monthly Debt 3000
Front end ratio13.33%  Back end ratio (too high) 63.33%

Here's an example of a monthly payment that exceeds the lending guidelines but is acceptable on the debt side.

Gross monthly income$6,000  Gross monthly income $6,000
Mortgage Payment $2,000  Mortgage Payment $800
   Monthly Debt  
Front end ratio (too high) 33.33% Back end ratio 13.33%

The lender seeks a balance between the front end payment ratio and the back end debt ratio. Both ratios must be within the lending guidelines for the loan program.

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 monthly loan payment when calculating the debt to income ratio, however, if the loan is deferred and an estimated payment is not available, the lender will "estimate" the student loan payment. 

FHA - After September 14, 2015, all student loan payments are used to qualify you, even when the current loan payment is deferred or set to zero. Lenders must determine a monthly payment, or count 2% of the balance as an estimate monthly payment (i.e. $20,000/balance X 2% = $400).

USDA loan- 1% of the deferred student loan balance is used for a monthly payment

Conventional loan - Most lenders will use 5% of the deferred student loan balance