Most homebuyers make their purchase decision based on the monthly mortgage payment. For many this is where the rubber meets the road if you will. For lenders too, monthly payment is very important. They use this amount to calculate the important Debt-to-Income ratio (DTI). Stocks have P/E ratios and mathematics has pi, which is the ratio of circumference of a circle to its diameter. Mortgage lenders have the DTI ratio.
When it comes to lending, everything revolves around DTI. As we’ll see later, you squeeze this number and you get lots of upset folks holding empty brown bags! The recent proliferation of low documentation loans has been a way of getting around the DTI. There are other reasons for using such loans but DTI is a major reason to choose one.
Why is DTI so important? There are many reasons, but essentially, this number indicates with little ambiguity whether or not you will be able to make the monthly payment on your mortgage. Today’s generation overlooks the fact that when a bank lends you money they expect to be paid back in full. The generation from the depression era has a much better grasp of this concept. The DTI is a lenders best way of determining how reliable you will be in paying back the massive amount of money they have lent you.
How is DTI calculated? DTI is calculated by dividing the total monthly credit obligations by your gross monthly income. The calculation only involves credit payments and does not include other obligations such as utilities, food, taxes etc.
There are in fact two aspects of the DTI ratio lenders evaluate. One is the front ratio (also the housing ratio) and the other is the back ratio. The front ratio is your total housing payment (which includes principle, interest, taxes and insurance (PITI)) divided by your gross income. The back ratio includes all credit payments (credit cards, auto etc.) with the PITI and divides it by your gross income.
For example, if your gross monthly is $4000 and you have a $1000/month mortgage payment (PITI), $400/month auto payment and $300/month credit card payment then your front ratio is 25% and your back ratio is 42.5%. In essence almost 43% of your gross income is going towards servicing debt. Don’t forget that taxes can take away another 28% of income, leaving you with just 29% for food, utilities, entertainment and other expenses.
As you can see, a higher DTI squeezes against the other essential expenses. Also, don’t forget life happens. The US currently has a negative savings rate, so when your garage door caves in on you, you better have a cushion to take care of this added unexpected expense. This is why lenders pay such close attention to DTI. No one wants to generate a whole bunch of black smoke when the rubber meets the road!
Next week. How DTI is used to determine the loan size.
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