“I got denied for a mortgage because I have too much debt”

This is a phrase I hear all the time. Unfortunately, it’s a statement that is never actually true, and it’s also a sign to me that whoever that customer previously applied with did them a disservice in two potentially significant ways. First, they failed to properly explain exactly how and why the customer was denied. This is important, because it means they also didn’t walk the customer through how they can correct the situation, which is the second way in which they were underserved by that lender. Additionally, it is evidence to me that they may not have fully investigated the options available to that customer.

What actually happened is that the customer was denied because their “DTI” was too high. What is a “DTI”? DTI stands for Debt-To-Income ratio, which is a calculation used by lenders to determine your ability to repay the loan for which you are applying. There is no maximum amount of debt that you may have in order to qualify for a mortgage, nor is there even any calculation whatsoever that takes into account your total dollar amount of debt. Instead, lenders care about the MONTHLY amount required to “service” (pay) that debt. Specifically, they calculate that amount as a percentage of your monthly income, and report it as a ratio.

If you remember anything about ratios from school (or have shopped for a TV in the last ten years), you probably remember something along the lines of “4:3” or “16:9”. Lenders take it a step further and divide the first number by the second number to create a percentage, round it to two decimal points, then drop the percentage sign to make it a number between 1 and 100 (eg. “34.56”).

For each application, lenders actually calculate two DTI figures; the “Housing Ratio” and the “Debt Ratio”, more commonly called the “front” and “back” end ratios by people in the biz. Both of these figures have the same denominator (the number on the bottom of the fraction, for those whose math is a bit fuzzy); your GROSS monthly income. That is, your monthly income BEFORE taking out taxes or any other deductions from your income. This number is also an aggregate of all sources of income for all borrowers who will be on the loan, AND is calculated to extreme accuracy (more on this in later entries about income).

The numerator (the top number) in the Housing Ratio is your proposed monthly housing expense AFTER completing the mortgage. For the purchase or refinance of a primary residence, this includes the proposed mortgage payment, plus monthly figures for property taxes and homeowners insurance (regardless of whether they will be included in the mortgage payment, or how often they are paid) and any other obligations to maintain ownership and clear title to the home, such as HOA dues, flood insurance, LID assessments, etc… It does NOT include utilities or other maintenance, such as electricity, water, sewer, garbage, etc…(unless they are included in the HOA dues). For example, lets say a customer’s income is $4,000 per month, and their mortgage payment will be $750, plus $200 in property taxes, and $50 for insurance, for a total of $1,000. 1,000/4,000=.25, or 25%. Their “front end” ratio would be 25.00. If you are purchasing or refinancing a second home or investment property, the calculation is the same, except that it will be based on your existing financing on your primary residence, rather than the new loan.

The numerator for the Debt Ratio is everything that is included in the Housing Ratio PLUS the monthly payments for any and all debt in your name (with a few exceptions). This includes minimum payments on any credit cards, car loans, or anything else that would appear on your credit report. You are also required to disclose any private loans or debts so they can be included. To continue the example from the previous paragraph, lets assume that the customers also have a credit card with a $50 minimum payment, a car loan with a $250 monthly payment, and student loan payments of $100 a month. 1,000+50+250+100=1,400. 1,400/4,000=.35, or 35%. Their “back end” ratio is 35.00.

Different lenders handle the calculations for second homes and investment properties differently, but the bottom line is that the net impact of those properties is included in the Debt Ratio as well (rental income minus expenses). There are also certain debts that can be excluded from this calculation for certain types of loans, which is one example of why it is always a good idea to have a professional review your application and credit report to determine your DTI for a specific loan scenario.

So what is an acceptable DTI ratio? This is the question that inspired me to write this piece. I’ve seen more misinformation regarding acceptable DTI ratios in the media and online than I can even fathom. “Front end” ratios are always calculated, but rarely used by lenders. Increasingly, lenders are relying almost entirely on the “back end” or Debt Ratio alone to determine a borrower’s ability to repay the loan. And this make sense, because people make all sorts of personal decisions about how to manage their finances, and the “back end” ratio takes everything into account without prejudice. The bottom line is that, for the vast majority of mortgage transactions, a back end ratio of 45.00 or lower is acceptable, and in a few rare cases, a ratio up to 50.00 may be approved. There are also some programs and situations in which the ratio will need to be lower. Again, this is why it is important to provide a professional with a complete loan application so that they can properly calculate these figures and tell you whether they will work for a given financing scenario.

I hope that this has helped you understand the all-important DTI ratios, and encourage you to contact me with any additional questions or thoughts.