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Today I’m explaining a bit about the differences between the DTI ratio for conventional loan (or debt to income ratio) vs other home loan types and why it’s important when buying a house. The definition of debt to income ratio is simply debt divided by income. But it’s a little more complicated than that when calculating. Let me break it down for you.
If you’d rather watch a quick video, I’ve summed up what is DTI ratio in less than 5 minutes. Don’t forget to subscribe to my YouTube channel for more practical money tips for the free-spirited nerd!
There are two different variations of a DTI ratio for conventional loan to consider when lenders are determining your eligibility for credit. There’s the front-end ratio and the back-end ratio. Both are equally important.
What is Front-End DTI Ratio for Conventional Loan
The front-end ratio is easy to remember because it covers housing expenses. If you own a home or are applying for a home loan, this is the PITI, or principal, interest, taxes, and homeowners’ insurance costs (per month) divided by your gross monthly income. Stay with me here for this example:
Principal is the part of your monthly payment that is allocated towards the original balance of the loan. So let’s say you borrowed $200,000 on a 30 year fixed mortgage. That $200,000 is your principal balance.
Interest is pretty self-explanatory, but it’s the amount of your payment that goes towards the interest every month. Have you ever read the amortization schedule on a 30 year home mortgage?! That’ll drive ya to drink!
Taxes are usually paid in an escrow account with your lender so they can pay the tax bill each year when you’re assessed.
Insurance is your mortgage insurance premium. This is also paid in escrow through your lender.
When you add up your total monthly payment, including each of these housing expenses and divide that number by your gross monthly income (hence the term debt to income), you’ll come up with a percentage. According to The Lenders Network, as I’m writing this, in 2018, a 36% DTI ratio is generally considered to be a very comfortable position. However, that ratio can be stretched to 43% in some cases, and maybe even higher than 45% if you have strong compensating factors such as a large down payment, large cash reserves, or an excellent credit score. Dave Ramsey, however, suggests that you should never purchase a home with a greater term than 15 year-fixed, and you should never exceed monthly DTI Ratio of 25% of take-home pay. Remember when lenders calculate what is DTI ratio, they will be looking at gross income. The main takeaway is that you don’t want to be house poor, with a HUGE chunk of your income going towards the mortgage payment. There are so many unknowns and things that could change in the next 15-30 years!
So let’s say your gross income is $6000 per month, and your house payment, with PITI, is a total of $1200 per month. Your front-end debt to income ratio would be 1200/6000 = .20, or 20%.
What is Back-End DTI Ratio
When calculating the back-end DTI, lenders take the same approach as with the front-end DTI, but they add all recurring monthly debts and obligations, such as child support or alimony payments.
Using the same example above, where your gross monthly income is $6000, and your house payment is $1200 per month, let’s add up your other debts and obligations.
Let’s assume you pay $700 in car payments, $300 minimum payments between all credit cards, and child support payments of $800 per month. Your total expenses, including your home equals $1200 + $700 + $300 + $800 = $3000. Now divide your total debt payments by your monthly gross income. 3000/6000, and you have a back-end DTI of 50%, so 50% of your total income is going towards debt and obligations. That’s a lot of money! Obviously, child support would likely stop at a time determined in your divorce decree, so the only thing you can control are your debts. Paying off your debt will free up your income, giving you more money to live the life you’ve always dreamed of (or live and give like no one else, as Dave says).
Whether or not you own a home, you need to calculate your DTI ratio for conventional loan so you can see how much money you could be adding to your retirement or college savings for the kids (especially if you’re in your 40’s with no college savings or retirement). The bottom line is when looking at what is DTI ratio, you need to know your numbers so you can be prepared to build financial wealth. Your biggest wealth-building tool is your income, so by calculating your DTI, you can figure out ways to pay off debt and free up more income to go into savings. You also might want to check out the post I wrote on credit utilization and how it can help build your credit score.
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