In home loans, the Debt-to-Income (DTI) Ratio is the way a bank or lender determines how much you can afford in your mortgage payment. Basically, it's the total percentage of a borrower's monthly gross income that goes toward paying off debts, comparing an individual's debt payments to the income they generate. It's considered very important and useful in mortgages, because it allows lenders to know the likelihood of the borrower repaying the loan. To qualify for a mortgage package, the DTI must be a certain percentage. Less debt means more borrowing power.
Practically, the higher this ratio, the harder there is on the individual to pay off his or her debts. If the ratio is too high, accessing other forms of financing will be difficult to achieve. Lenders use DTI ratios to be certain that you will not go beyond your limits with your loan and will be able to repay it.
There are two main types of DTI, written in the format x/y. These are the "front" ratio and the "back" ratio.
The front ratio is the percentage of monthly gross income that goes toward housing costs, including the principal, interest, taxes, insurance, mortgage insurance premium, hazard insurance premium, property taxes.
The back ratio indicates the percentage of your monthly gross income that goes to pay all your debts, including front ratio payments. The added payments are car payments, installment loans, child support, alimony, student loans, credit card debt, and so on.
There are guidelines regarding DTI ratio limits, and they are quite flexible. However, in case you make a small down payment for a mortgage, the guidelines become more rigid, as the risk the lender takes becomes higher. In the same way, the guidelines are more rigid if you have marginal credit, and they also vary according to the loan package.
Typically, the maximum debt-to-income ratio will range between 40 and 50%, although it varies depending on the mortgage lender.
Ultimately, keeping your debts always manageable is paramount if you want financial security. DTI ratios are great tools that enable you to assess whether your debts are starting to get out of control. Once you know your DTI, you can also have a better understanding of how a lender views your situation and whether they will give you the loan package you want. Before setting the loan amount, lenders always study DTI's to see how much of the loan the borrower can handle.
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