Debt to income ratio or debt income ratio or DTI is simply the portion of your gross income that you use for paying off your outstanding bills and other debts. Banks and lenders use debt to income ratio as an important indicator to work out whether a borrower qualifies for a loan and how much mortgage he can afford.
The formula for calculating debt to income ratio is – debts/gross income.
How debt to income ratio works ?
There are two types of debt to income and they are as follows:
Front ratio: This ratio is also known as front-end ratio or housing expense ratio. This ratio shows the portion of your gross monthly income before tax that is utilized towards your mortgage payments. As a usual rule of thumb, your monthly mortgage payment incorporating interest, principal, homeowners insurance and taxes must not go over 28% of your gross monthly income. For calculating the front ratio, just multiply your gross annual income by 0.28. Subsequently, divide it by 12 (months). The outcome is your maximum front-end ratio.
Back ratio: The back ratio or back-end ratio or total debt to income ratio indicates the portion of your gross monthly income that is utilized towards all your loan obligations such as car loans, mortgages, credit card bills, student loans, alimony and child support and condominium fees. The rule of thumb is your total monthly debt payments must not be more than 36% of your gross monthly income. For figuring out your back-end ratio, just multiply your gross annual income by 0.36 and subsequently divide it by 12 (months). The outcome is your maximum permissible back-end ratio.
Why debt to income ratio is so significant for you ?
Mortgage lenders get an idea about your financial condition from your debt to income ratio. If your debt to income ratio is low, then lenders would not hesitate to approve you for a loan. In contrast, if your debt to income ratio is more than 36%, then lenders would be doubtful about your repayment capacity and balk to offer you the loan. Hence, you must try to keep this ratio at a low level.
