Long gone are the days of the “liar loans” through which a mortgage applicant would simply state their income and the lender would accept it regardless of how reasonable or unreasonable the stated income appeared. Some of these loans even avoided discussing income all together. Irresponsible lending, such as this, contributed to the foreclosure crisis of 2008 which practically brought the world’s economy to its knees.
More important than ever, mortgage lenders must be able to reasonably determine that the borrowers to whom they lend money for home financing are able to repay those debts. Debt-to-Income (DTI) ratios are what the mortgage industry uses to ascertain an applicant’s ability to repay the debt that he or she desires. There are two types of DTI ratios that the industry typically considers when doing so:
1. The Housing Expense (front-end) DTI Ratio and
2. The Total Expense (back-end) DTI Ratio.
The Housing Expense (front-end) DTI Ratio
The Housing Expense Ratio represents the cost of owning the property in relation to the borrower’s gross monthly income. To calculate the front-end DTI ratio, the lender must add together all of the monthly equivalencies of all mandatory costs associated with owning the property to ascertain their sum total. This sum total is then divided by the borrower’s gross monthly income to determine the borrower’s Housing Expense Ratio.
So what constitutes mandatory expenses associated with owning a home? First of all, I must make it clear that it makes no difference who is responsible for paying the actual housing expense. Whether the homeowner pays it directly to the individual or entity to whom or to which it is owed or the mortgage servicer pays it on the borrower’s behalf through their escrow account is irrelevant. As long as the expense is a mandatory expense associated with owning the home, it must be considered when calculating the borrower’s DTI ratios.
Examples of mandatory homeownership obligations consist of:
• The mortgage’s principal and interest (P&I) payment
• Any P&I payment associated with any subordinate lien
• Real estate taxes
• Homeowner’s insurance
And, if applicable:
• Mortgage insurance
• Mandatory flood insurance
• Homeowner’s Association (HOA) dues
• Common charges
• Maintenance fees
• Condominium dues
• Co-op fees
• PUD fees
• Ground rents
Notice that I did not include utilities in this list. That’s because we never consider the cost of utilities in calculating DTI ratios. An individual may owe on a mortgage and/or own a home without ever being required to establish utilities.
When calculating DTI ratios, everything considered must always be translated into its monthly equivalence. Consider the following example. A borrower earns $3,900 bi-weekly. Her mortgage loan’s monthly principal and interest payment is $1,195. Her real estate taxes currently amount to $3,000 paid semi-annually. Her homeowner’s insurance costs $850 annually, and she is also required to pay quarterly HOA dues amounting to $450. To calculate her front-end DTI ratio, therefore, her lender would translate all of those items into their monthly equivalencies as follows:
Income: $3,900 bi-weekly x 26 equals the annual equivalence of $101,400. This annual income must then be divided by 12 to calculate her monthly income of $8,450.
Monthly P&I Payment: $1,195
Real Estate Taxes: $3,000 paid semi-annually x 2 equals the annual equivalence of $6,000. This annual tax must then be divided by 12 to calculate its monthly equivalence of $500.
Homeowner’s Insurance: $850 paid annually must be divided by 12 to calculate its monthly equivalence of $70.83.
Homeowner’s Association Dues: $450 paid quarterly x 4 equals the annual equivalence of $1,800. This annual dues amount must then be divided by 12 to calculate its monthly equivalence of $150.
Now that we have translated everything into their monthly equivalencies, we must add together all of these monthly debt equivalencies to derive the monthly debt sum total: $1,195 + $500 + $70.83 + $150 = $1,915.83
Finally, we divide the monthly debt sum total of $1,915.83 by the monthly income amount of $8,450 to conclude this borrower’s front-end DTI ratio to be 22% (1,915.83 / 8,450). This tells the lender that all of the mandatory costs associated with owning this property consume 22% of the borrower’s gross monthly income. Regardless of the mortgage product selected, a front-end DTI ratio of 22% indicates affordability.
The front-end DTI ratio is a good indicator of housing payment shock. This considers a mortgage applicant’s current housing expense in relation to the proposed housing expense associated with the loan that he or she is considering. The Housing Expense ratio, however, is never an accurate indicator of an applicant’s ability to repay their debt. In fact, Veterans Administration loan underwriting parameters avoid considering the front-end DTI ratio altogether. For a more conclusive determinant of affordability, the lender must calculate and consider the borrower’s Total Expense (back-end) DTI ratio.
The Total Expense (back-end) DTI Ratio
Just because a borrower may be able to afford the costs associated with owning the desired property doesn’t mean that he or she will be able to maintain solvency. What if the borrower, with a 22% front-end DTI ratio, was obligated to so much peripheral debt that, with everything considered, her debt load actually exceeded her total income earned? Yes, the housing expense may be low, but, if on top of that, she was spending more than she was earning, she might very well ultimately default on her mortgage. This is why the lender must always consider the back-end DTI ratio.
To calculate the back-end DTI ratio, the lender calculates the borrower’s gross monthly income in the same manner as it did when calculating the front-end ratio. Additionally, the mandatory housing expense is combined with the sum total of all consumer debt and long-term debt before dividing that sum total by the borrower’s gross monthly income.
Consumer debt consists of the monthly minimum payments owed on credit cards, loans, and leases. The lender typically ascertains that information through the borrower’s credit report. Long-term debt represents all financial obligations to which the borrower is obligated that fall outside of his or her housing and consumer debt. Examples of long-term debt include mandatory/obligatory alimony, child support, separate maintenance, and any other recurring financial obligation about which the mortgage loan originator learns.
Let’s review the previous example while including some additional components. The borrower’s monthly income is $8,450. Her housing expense totals $1,915.83. The borrower also pays a monthly car payment of $350, owes minimum credit card payments of $245, has a student loan payment of $410, and is obligated to pay child support amounting to $1,700 per month. In calculating her total expense ratio, the lender will determine her entire monthly debt obligation and divide that sum total by her gross monthly income:
Housing Expense: $1,915.83
Consumer Debt: $1,005.00
Long-Term Debt: $1,700.00
Total Debt: $4,620.83
When the borrower’s total monthly debt is then divided by her gross monthly income of $8,450, her back-end DTI ratio is concluded to be 54%.
Now that we’ve determined that the borrower’s DTI ratios are 22 / 54, we have a much more accurate understanding of the likelihood of her being able (or unable) to repay her debts. What these ratios conclude is that this borrower’s housing expenses consume 22% of her gross monthly income while the total amount of her debts constitute 54% of her gross monthly income. This indicates that, although she may be able to easily afford her house, when considering all of her debts combined, she appears to be spreading herself too thin.
Debt-to-Income Mortgage Guidelines
When originating a mortgage product, the loan originator must be aware of the product’s DTI tolerance guidelines. Most mortgage products establish thresholds defining the highest DTI ratios that the borrower may have in order to qualify for that particular loan product. Honoring this requirement ensures that, after an individual pays their housing, consumer, and long-term debt obligations, he or she still has enough money remaining for expenses associated with things such as income taxes, food, utilities, fuel, insurance, clothing, healthcare, and all of life’s other costs.
In the absence of product-specific DTI guidelines, the following generalized guidelines should be considered:
• Conventional loans: 28 / 36
• FHA loans: 31 / 43
• VA loans: N/A / 41
• USDA loans: 29 / 41
A lender will find confidence in their applicant’s ability to repay a conventional mortgage if the housing expense associated with owning the property does not exceed 28% of the borrower’s gross monthly income. Additionally, all of the borrower’s expenses should, ideally, fall within 36% of his gross monthly income. The same applies, as stated above, to FHA, VA, and USDA loans. Lastly, it’s important to always remember that these are simply guidelines and compensating factors may allow for the tolerance of higher DTI ratios.
Don’t miss next week’s article through which I explain how to calculate loan-to-value (LTV), combined loan-to-value (CLTV), and total loan-to-value (TLTV).