Real Estate Insight

When calculating how much home you can afford to buy, lenders use debt to income ratios (DTI) to determine how much you can safely borrow. There are two ratios used; front and back end ratios.

The front end ratio is a measurement of just the total monthly house obligations. The acronym PITI is commonly used. It stands for Principle, Interest, Taxes and Insurance. The Principle and Interest represents the montly mortgage payment, Taxes are the property taxes broken down to monthly increments, and Hazard Insurance to insure the structure from fire, natural disasters, etc. Although not part of the PITI acronym, monthly mortgage insurance payments and Association dues/fees if applicable would also be included when calculating the total monthly house expenses. The total of all of these monthly house expenses divided by your monthly gross income will be your front end ratio.
For conforming loans, the front end ratio is typically 28%
For FHA loans, the front end ratio is 31%.
Example:
Principle and interest payments= $1500
Property Taxes= $250
Insurance= $250
Total housing expenses= $2000

Gross annual income= $85,000
Gross monthly income= $7083 ($85,000 / 12 months)

Front end DTI= $2000 / $7083 = 28%

The back end ratio adds all monthly recurring debt to the total house debt to arrive at the back end ratio.

For conforming loans, the back end ratio is typically 36%

For FHA loans, the ratio is 43%.

VA loans only use one ratio of 41%

Example:
Car payment= $200
Credit card payments= $200
Student loan= $150
PITI= $2000
Total monthly debt obligations= $2550

Back end DTI = $2550 / $7083 = 36%

When a borrower’s DTI exceeds conforming ratios of 28/36, the borrower will have to consider nonconforming loans that allow higher debt ratios, some as high as 55%.  These nonconforming loans, also known as sub-prime loans, come with higher interest rates to accommodate for the higher risk to the lender.  With the recent meltdown in the mortgage industry due to the high rate of sub-prime loans defaulting, the industry will probably see a market correction that will revise these high sub-prime ratio limits downward.

Calculating FHA loans are a little different. You can click on this link to learn how to calculate FHA DTI ratios. http://www.crystalclearmarket.com/?p=142

Hope this helps. Until next time, Happy house hunting.

Elliot Lau