Debt-to-income ratio
Encyclopedia
A debt-to-income ratio is the percentage of a consumer's monthly gross income
that goes toward paying debts. (Speaking precisely, DTIs often cover more than just debts; they can include certain taxes, fees, and insurance premiums as well. Nevertheless, the term is a set phrase
that serves as a convenient, well-understood shorthand.) There are two main kinds of DTI, as discussed below.
In the U.S., for conforming loans, the following limits are currently typical:
Back ratio limits up to 55 have become common in recent years for nonconforming loans. The recent spate of defaults by subprime borrowers
may produce a market correction that revises these limits downward again. However, how large the adjustment remains to be seen.
and the VA
(through the G.I. Bill) led the creation of a mass market in 30-year, fixed-rate, amortized mortgages. It was not until the 1970s that the average working person carried credit card balances (more information at Credit card#History). Thus the typical DTI limit in use in the 1970s was PITI<25%, with no codified limit for the second DTI ratio (the one including credit cards). In other words, in today's notation, it could be expressed as 25/25, or perhaps more accurately, 25/NA, with the NA limit left to the discretion of lenders on a case-by-case basis. In the following decades these limits gradually climbed higher, and the second limit was codified (coinciding with the evolution of modern credit scoring
), as lenders determined empirically how much risk was profitable. This empirical process continues today.
Gross income
Gross income in United States tax law is receipts and gains from all sources less cost of goods sold. Gross income is the starting point for determining Federal and state income tax of individuals, corporations, estates and trusts, whether resident or nonresident."Except as otherwise provided" by...
that goes toward paying debts. (Speaking precisely, DTIs often cover more than just debts; they can include certain taxes, fees, and insurance premiums as well. Nevertheless, the term is a set phrase
Set phrase
A set phrase or fixed phrase is a phrase whose parts are fixed, even if the phrase could be changed without harming the literal meaning. This is because a set phrase is a culturally accepted phrase. A set phrase does not necessarily have any literal meaning in and of itself. Set phrases may...
that serves as a convenient, well-understood shorthand.) There are two main kinds of DTI, as discussed below.
Two main kinds of DTI
The two main kinds of DTI are expressed as a pair using the notationx/y (for example, 28/36).- The first DTI, known as the front-end ratio, indicates the percentage of income that goes toward housing costs, which for renters is the rent amount and for homeowners is PITIPITIIn relation to a mortgage, PITI is an acronym for a mortgage payment that is the sum of monthly principal, interest, taxes, and insurance. That is, PITI is the sum of the monthly loan service plus the monthly property tax payment, homeowners insurance premium, and, when applicable, mortgage...
(mortgageMortgage loanA mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
principal and interestInterestInterest is a fee paid by a borrower of assets to the owner as a form of compensation for the use of the assets. It is most commonly the price paid for the use of borrowed money, or money earned by deposited funds....
, mortgage insuranceMortgage insuranceMortgage insurance is an insurance policy which compensates lenders or investors for losses due to the default of a mortgage loan. Mortgage insurance can be either public or private depending upon the insurer...
premium [when applicable], hazard insuranceHome insuranceHome insurance, also commonly called hazard insurance or homeowner's insurance , is the type of property insurance that covers private homes...
premium, property taxProperty taxA property tax is an ad valorem levy on the value of property that the owner is required to pay. The tax is levied by the governing authority of the jurisdiction in which the property is located; it may be paid to a national government, a federated state or a municipality...
es, and homeowners' association dues [when applicable]). - The second DTI, known as the back-end ratio, indicates the percentage of income that goes toward paying all recurring debt payments, including those covered by the first DTI, and other debts such as credit cardCredit cardA credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
payments, car loan payments, student loan payments, child support payments, alimony payments, and legal judgments.
Example
In order to qualify for a mortgage for which the lender requires a debt-to-income ratio of 28/36:- Yearly Gross Income = $45,000 / Divided by 12 = $3,750 per month income.
- $3,750 Monthly Income x .28 = $1,050 allowed for housing expense.
- $3,750 Monthly Income x .36 = $1,350 allowed for housing expense plus recurring debt.
Conforming loans
In the U.S., for conforming loans, the following limits are currently typical:
- Conventional financing limits are typically 28/36.
- FHAFederal Housing AdministrationThe Federal Housing Administration is a United States government agency created as part of the National Housing Act of 1934. It insured loans made by banks and other private lenders for home building and home buying...
limits are typically 31/43. - VAUnited States Department of Veterans AffairsThe United States Department of Veterans Affairs is a government-run military veteran benefit system with Cabinet-level status. It is the United States government’s second largest department, after the United States Department of Defense...
limits are only calculated with one DTI of 41. (This is effectively equal to 41/41, although VA does not use that notation.) - USDA 29/41
Nonconforming loans
Back ratio limits up to 55 have become common in recent years for nonconforming loans. The recent spate of defaults by subprime borrowers
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....
may produce a market correction that revises these limits downward again. However, how large the adjustment remains to be seen.
Historical limits
The business of lending and borrowing money has evolved qualitatively in the post-World-War-II era. It was not until that era that the FHAFederal Housing Administration
The Federal Housing Administration is a United States government agency created as part of the National Housing Act of 1934. It insured loans made by banks and other private lenders for home building and home buying...
and the VA
United States Department of Veterans Affairs
The United States Department of Veterans Affairs is a government-run military veteran benefit system with Cabinet-level status. It is the United States government’s second largest department, after the United States Department of Defense...
(through the G.I. Bill) led the creation of a mass market in 30-year, fixed-rate, amortized mortgages. It was not until the 1970s that the average working person carried credit card balances (more information at Credit card#History). Thus the typical DTI limit in use in the 1970s was PITI<25%, with no codified limit for the second DTI ratio (the one including credit cards). In other words, in today's notation, it could be expressed as 25/25, or perhaps more accurately, 25/NA, with the NA limit left to the discretion of lenders on a case-by-case basis. In the following decades these limits gradually climbed higher, and the second limit was codified (coinciding with the evolution of modern credit scoring
Credit score
A credit score is a numerical expression based on a statistical analysis of a person's credit files, to represent the creditworthiness of that person...
), as lenders determined empirically how much risk was profitable. This empirical process continues today.