Way before social media made acronyms like “BRB” and “LOL” all the rage, there were financial abbreviations like “P&L” and “DTI” floating among us. And while most lay people probably recognize the shorthand for “Profit & Loss,” “Debt-to-Income Ratio” is lesser known and understood. But it needs to be…especially for folks looking to buy a home.
The good news? It’s pretty simple.
Definition of Debt
"Debt" as you know, is what you need to pay (or will owe) in general, while “income,” of course, is what you earn. So “Debt-to-Income” Ratio is simply a formula (X/Y) that lenders use to determine what you can afford home-wise/mortgage-wise based on your gross salary. It determines what’s doable and whether it’s safe for them to lend money to you.
Here’s how to understand the numbers behind X/Y:
X, or the "front-end ratio" shows how much of one’s salary can go toward mortgage principal and interest, mortgage insurance, hazard insurance, property taxes, and, if applicable, homeowner’s association dues.
Y, or the "back-end ratio" goes toward paying all recurring debt expenses…both the costs above (since they are recurring), and things like credit cards, car loans, and student loans payments.
So…suppose a lender requires a DTI of 28/36 (this is typical). You’d multiply your gross annual income times .28 to get your allowance for housing expenses, and your gross income times .38 to see what you can spend on recurring debt, including housing expenses.
If the lender sees that achieving this debt is manageable for you based on your income, you’re likely to qualify for a mortgage with them.
Two additional points:
1.) Just because you qualify for a mortgage, doesn’t mean you should necessarily get one. Do an honest inventory of yourself and your future before you make such a large commitment.
2.) Just because you don’t qualify for a mortgage, does not mean all hope is lost for getting one. If you can pay off some of your debt, do so and revisit. If you can’t and have a co-signer with sufficient income/credit who is willing to guarantee your payment, that may work as well.