When shopping for a mortgage loan, you will likely encounter the term back-end debt-to-income ratio, or “back-end DTI” for short. This seemingly harmless number actually has the power to stop your mortgage loan in its tracks — all by itself. As a result, all borrowers should know what DTI ratios are and how they work.
Definition: A back-end debt-to-income ratio is a comparison between the amount of money a person earns (measured in gross monthly income), and the amount he or she spends on all recurring monthly debts including the housing payment. It is typically expressed as a percentage, and is one of the most important qualifying factors for mortgage borrowers.
Back-End Debt-to-Income Ratios at a Glance
The back-end debt ratio has the potential to make or break your chances of getting approved for a home loan. Yes, it’s that important. So let’s go beyond the basic definition above and take a closer look at this all-important percentage…
- Debt-to-income (DTI) ratios are a numerical comparison between a consumer’s monthly recurring debts and his or her gross monthly income. These ratios are typically expressed as a percentage. For instance, a consumer with a debt ratio of 40% uses 40% of his/her gross monthly income to cover his monthly recurring debts.
- These ratios are used as risk-assessment tool by all types of creditors and lenders, including mortgage lenders. Credit scores are also used for risk analysis. Lenders want to know how much risk a particular borrower brings to the table. So they use various metrics and measurements to determine this, including the DTI.
- It’s all a matter of statistics. Borrowers with higher debt levels are statistically more likely to default on their loans, particularly mortgage loans. They are therefore deemed high-risk borrowers.
- In short, debt ratios help lenders measure a borrower’s ability to repay a loan.
- In the mortgage lending industry, there are two types of debt-to-income ratios: front-end and back-end.
- The front-end debt ratio (also known as the housing expense ratio) is a comparison between the borrower’s monthly housing expense and gross monthly income/earnings. In a typical mortgage scenario, housing-related expenses include the mortgage principal, the interest being paid on the mortgage, property taxes, and homeowners insurance premiums. These items are collectively known as PITI, short for Principal, Interest, Taxes and Insurance.
- The back-end debt ratio (also known as the total debt ratio) considers all recurring monthly expenses, including mortgage payments, credit card payments, car payments and the like.
- The back-end DTI is most important from a lender’s perspective, because it reveals the borrower’s total monthly debt burden. It helps lenders assess the borrower’s ability to repay the mortgage loan obligation, based on his or her current financial situation.
- The standard DTI limits for conventional mortgage loans are 28/36. This means the front (housing expense) ratio should not exceed 28%, while the back-end (total) debt ratio should be no higher than 36%. Stated differently, the borrower’s combined recurring monthly expenses should use up no more than 36% of his or her gross monthly income. This is just a rule of thumb. Exceptions can be made.
- The standard DTI limits for government-insured FHA home loans are 31/43. In this scenario, the back-end debt ratio can be as high as 43%. Here again, exceptions can be made for borrowers who are well-qualified in all other areas.
While the back-end debt-to-income ratio can derail a mortgage all on its own, most lenders consider the bigger picture. For instance, borrowers with larger down payments, significant assets, and excellent credit are often allowed to exceed the DTI “rules” mentioned above.
Calculating Your DTI Ratio
We encourage borrowers to go into the mortgage process with an accurate picture of where they stand. One of the ways you can do this is by calculating your back-end debt ratio for yourself, before you start applying for loans.
All you need is a list of your recurring monthly debts (including your estimated mortgage payments), your gross monthly income, and a basic calculator. The math itself is straightforward. To calculate your back-end DTI ratio, you would simply divide your total monthly debt payments by your total gross monthly income.
Here’s the formula:
All recurring monthly debts (combined) ÷ gross monthly income = back-end debt ratio
Just remember that mortgage lenders qualify borrowers based on the bigger picture. You probably won’t be automatically disqualified for a certain loan amount based solely on your back-end DTI ratio. But the math is still worth doing, because it helps you assess your qualifications and limitations as a borrower. You’re just trying to get a feel for your maximum loan limit, based on your current debt situation.
New Developments: FHA And Qualified Mortgage (QM) Rules
There are a couple of new lending rules you should know about, where the back-end debt ratio is concerned. They have to do with FHA loan requirements and the new Qualified Mortgage rule that took effect in 2014.
New Rules for FHA Loans
In 2013, the Department of Housing and Urban Development (HUD) announced a new rule for FHA loans. It applies to borrowers with credit scores below 620 and back-end debt ratios above 43%. In short, borrowers who fall within this range will undergo additional scrutiny when qualifying for an FHA loan. The loan file must be manually underwritten, which means it cannot be automatically approved by the FHA underwriting system (as it might for other borrowers).
Additionally, the underwriter must find compensating factors that justify the borrower’s approval. Compensating factors might include significant cash reserves, or a long history of making mortgage payments on time.
The Qualified Mortgage Rule
The Qualified Mortgage (QM) rule also sets a back-end debt limit at 43%. This rule was announced in January of 2013 and took effect in January 2014. The QM rule was mandated by the Dodd-Frank Act, in response to reckless lending practices that contributed to our nation’s financial crisis.
A 2013 fact sheet issued by the Consumer Financial Protection Bureau (CFPB) states the following: “QMs generally will be provided to consumers who have a total debt-to-income ratio … less than or equal to 43%.”
When viewed together, these new rules seem to suggest that the government is drawing a line at 43%, where back-end DTI ratios are concerned. As mentioned earlier, there are exceptions to most of these rules. But the general trend is clear. Federal banking regulators feel that a total debt ratio of 43% is the upper “safe” limit for borrowers.
Conclusion: The back-end debt ratio is a numerical comparison between a borrower’s total recurring debts and his or her gross monthly income. It is one of many risk indicators used by lenders when qualifying borrowers for home loans. The standard DTI limit for conventional loans is 28% on the front end, and 36% on the back-end. The standard limit for FHA-insured loans is 31/43. The Qualified Mortgage rule also places an upper limit at 43%. There are exceptions to most of the requirements mentioned in this article. Borrowers should not assume their DTI numbers will disqualify them for a mortgage. The only way to know for sure is to apply for a loan.