Debt ratios are utilized by lenders during the loan approval process. It’s an important piece, just one of several. Other factors such as credit, employment and assets are also pieces of the approval puzzle. Debt ratios on the other hand are the primary tool to determine affordability. Today, most loan programs set the guidelines for debt ratios.
Debt Ratios Explained
For most programs, there are two such ratios, a ‘front’ and a ‘back.’ A front ratio looks at the number of total monthly credit obligations divided by gross monthly income. Doing so produces a percentage. This percentage is the ratio. For example, say someone has a house payment of $2,500, which includes property taxes, insurance and private mortgage insurance, or PMI, when needed, along with the primary principal and interest amount. The principal and interest number is a function of the loan amount, loan term and interest rate. Property taxes are set by state and local taxing authorities, insurance payment is provided by the homeowner’s insurance agent and annual premium and PMI.
Guidelines for Debt Ratios
Debt ratio guidelines are rarely hard and fast rules. For example, let’s say a loan program has a housing ratio requirement of 28 yet the actual debt ratio calculation comes to 33%, or simply stated as 33. The loan can still be approved even though the true ratio is higher than the recommended. Again, this is the front ratio.
The back ratio includes the house payment plus everything else. A common guideline for debt ratios for the back ratio might be 43 but can go as high as 50. How can someone get an approval when the actual debt ratios are higher than program guidelines? This typically happens when there are other positive factors in the file. These additional factors, commonly referred to by lenders as ‘compensating’ factors, include facets such as higher credit scores, a larger down payment or lots of liquid and non-liquid assets such as a bank or investment account.
Okay, so we know what the housing ratio should be, but what all is included in the back, or total debt ratio? We mentioned ‘other’ credit obligations, but what are they, specifically? First, the additional payments include amounts from revolving credit such as credit cards. The credit report will list a minimum monthly payment due. This is the amount the lender will include. Even if the account is paid off every month, the lender will still use what appears on the credit report. If in fact the amount has been paid off and the borrowers can provide documentation that the balance is indeed zero, lenders will factor that into the numbers.
Installment loans are also included. Installment loans are those used to finance a product or service and the monthly payments are fixed each month. They do not change unless the outstanding loan is refinanced or otherwise retired. A common installment loan would be a car payment. The monthly payments are typically fixed, and that payment is listed on the report and included with the back ratio. Consumers can pay off an installment loan to remove it from the debt ratio calculation.
A Few Exceptions
One twist, when the credit report shows the loan has less than 10 payments remaining, the payment on an installment loan is not included.
Another twist, when a car is leased and there are less than 10 payments remaining, the lender realizes that at the end of the lease, the car will be turned back to the lender. What will the borrower do at the end of the lease? Buy the car outright? Lease another?
Student loan payments are included in this back ratio. Daycare can be included as well. Other regular expenses are not included in the final debt ratio number. These other non-categorized expenditures include everyday items such as food, utilities and entertainment, to name a few.
Debt ratios are an important factor during the approval process. If you think you might be a bit too debt-heavy and won’t qualify for the loan you want, don’t make that decision by yourself. I can help prior to shopping for a home. Let’s work together to get you on track and preapproved for your next home.