Whenever you apply for a loan -- whether it's a car loan, mortgage or credit card -- your lender wants to feel secure that you can and will repay the money on time. When lenders evaluate borrowers to determine whether they are a safe investment, part of their calculation involves the borrower's debt-to-income ratio.
Debt-To-Income Ratio
A debt-to-income ratio (DTI) is a basic measurement lenders use to determine how much money you are taking in and how much money you have going out. For example, if you earn $10,000 a month and pay $2,000 per month to pay debts, you have a 20 percent debt-to-income ratio. A high DTI means you have a lot of debt and are at risk for financial difficulty. A low DTI means the opposite and shows you are a safer investment.
Front-End Ratio
A front-end DTI represents your housing payments, plus any related expenses, such as homeowner's insurance and property taxes. For example, if you earn $5,000 per month in gross income and pay $1,500 per month in mortgage, plus another $300 in insurance and taxes, you have a front-end DTI of $1,800 divided by $5,000, or 36 percent. Lenders typically prefer a front-end DTI of about 30 percent or lower, according to Truthful Lending.
Back-End Ratio
A back-end DTI represents the total amount of debt obligations you currently have, including your housing obligations. For example, if you make $5,000 per month, pay $1,800 for your housing needs plus another $700 for other loans, such as your car payment and credit cards, you have a total debt obligation of $2,500, and a back-end DTI of 50 percent. Lenders generally prefer you to have back-end DTI of 40 percent or less, according to Truthful Lending.
Other Factors
While knowing your DTI is important, especially when you are considering applying for a mortgage or determining how much you can spend on rent, it's not the only factor lenders use. Lenders also want to know how well you've handled credit obligations in the past, and they look at your credit score to determine this. Also, each lender sets its own standards for what it considers an acceptable DTI and credit score, so even if one lender refuses you, that doesn't mean all lenders will.
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