When qualifying to buy a home, there are actually two debt-to-income (DTI) ratios that you should be concerned with. The housing debt ratio (also called the “front-end ratio”) is commonly set at 28 percent of your monthly gross income. As an example, if you make $60,000 per year before taxes, this is $5,000 per month; $5,000 per month times .28 (28 percent) is $1,400 — so you can use $1,400 per month to cover monthly principal, interest, taxes, insurances and other mandatory housing-related expenses.
There is a second ratio of debt to income which also applies. This so-called “back-end” or “total debt” typically set at a conservative 36 percent of your monthly gross income; for a time, this moved to 38 percent, then 43 percent (the present qualified mortgage standard) but was routinely allowed to be exceeded for borrowers with great credit and sizable down payments. A “temporary exemption” for this for Fannie Mae and Freddie Mac can now allow for total DTIs to be as high as 50 percent (any debt above this hard cap will start to reduce the amount of mortgage you can borrow).
With a 50 percent DTI ratio, your total pre-tax debt load including your mortgage would be allowed to be $2,500 per month — that’s your mortgage and another $1,100 in required monthly payments. While this may be allowed, it’s probably not advisable to leverage yourself out to this level.
Why, you might ask? Because we are working with pre-tax figures. At $60,000 per year a single person would be in the 25 percent bracket for federal taxes. Depending on where you are, there may also be additional state and local taxes, plus pay reductions for social security, unemployment insurance and more. For working purposes, let’s reckon that 33 percent of your monthly gross income is lost to these items.
Subtracting 33 percent from $5,000, this leaves you with monthly after-tax income of $3,350; if you are at the full 50% back end DTI ratio, you would then subtract another $2,500 from this… leaving you with a grand total of just $850 per month to cover all other living expenses — food, cable, internet, cell phone, car insurance and everything else.
So what should your debt ratio be? For most borrowers, it’s probably something closer to the old traditional (and sustainable) 28 percent and 36 percent ratios. Using the example above, you could carry the same $1,400 in monthly housing cost, but the other debts you carry would total not more than perhaps $400 per month (for a total of $1,800 per month at a 36 percent DTI). Working through the example above, you would see $3,350 after taxes, subtract $1,800 from that for housing, leaving you with a much more workable $1,550 per month to sustain your life.
Certainly, there isn’t anything wrong with highly leveraging your income; however, this does carry some risks, such as difficulty making payments should an emergency financial situation arise. As well, being highly leveraged today probably isn’t a permanent situation (in fact, investors who buy these loans are betting on this), as some (or all) of the debts that are driving up the DTI ratio today may disappear in reasonably short order (i.e. a couple of years left on a student loan); as such, the DTI should naturally lower over time. This is also the case if your income is expected to rise measurably in the future, as higher income should have less trouble supporting a high debt load.
This answer was originally posted on Quora.