Mortgage Matters

Today is the initial installment of Mortgage Matters, where I will discuss a wide range of topics covering all aspects of the mortgage market. Our first discussion topic is debt-to-income ratios.

The Debt to Income Ratio:

First, we need to determine what goes into creating your debt to income ratios. The “debt” portion of debt to income covers only the payments you make on a monthly basis for installment loans, revolving debt, such as credit cards or lines of credit (for credit cards and lines of credit the minimum monthly required payment is used), and monthly payments for child support and/or alimony. It does not typically include your monthly utilities such as gas, water, electric, cell phones, cable/satellite television, or internet charges. It will also not include daily living expenses such as food, gas, clothing, or entertainment.

The income portion of your ratio is based on your gross income. This is the income you receive before taxes or any other subtractions to your paycheck are made. For example:

John makes $11.00 an hour and works a normal 40 hour work week with no overtime or bonuses.

His income calculation would be $11 X 40 hours X 52 week a year / 12 months = $1906.66 monthly income, before deductions. This amount is the income used to determine John’s debt to income ratio.

Note: If you are self-employed, make a large portion of your income on commission, overtime, or bonus your income is determined differently from above.

Now that we have determined how mortgage lenders determine your debt and your income we can look at how the look and use debt to income ratios. Mortgage lenders use two types of debt to income ratios when reviewing a mortgage application. The first ratio, often referred as the “housing to debt ratio” or the “front ratio”, is the housing to debt ratio. This ratio looks at what your new mortgage payment you are applying for versus your gross income. The industry guideline is that your front ratio should not exceed 28% of your income. So using John as an example:

John’s monthly income is $1906.66, if his proposed mortgage payment is $500 per month, including taxes and insurance (wouldn’t that be nice), his front ratio would be 26.22%. This payment would fit into the industry guideline, but just barely. The max payment to meet this guideline for John would be $533.86 per month.

The second ratio taken into consideration is called the total debt to income ratio, also known as the “backend ratio”. This ratio takes your proposed mortgage payment and any other monthly debts you may have (see above). The normal industry guideline varies slightly depending on the type of mortgage loan you are doing but typically the ratio should not exceed 36%. So referring to John again:

John has a proposed mortgage payment of $500 per month, his car payment is $250, and he has minimum payments on his credit cards of another $50 per month for a total of $800. If his income is $1906.66 per month his back ratio would be 41.96%, which exceeds the industry guideline.

Are John’s dreams of an affordable mortgage cooked? No, not necessarily. More on that to come!