DTI Defined
One of the primary factors affecting how much home you can afford is your debt-to-income ratio (“DTI”). DTI is the percentage of your gross monthly income used to pay debt. Lenders use two DTI components in determining how much house you can buy: front-end DTI and back-end DTI. In order to qualify for the purchase price you desire your DTI has to be within guidelines.
Front-end DTI represents the percentage of income your new monthly mortgage payment will make-up. Your monthly mortgage payment consists of your monthly principal and interest payment on the home loan + monthly homeowner’s insurance expense + monthly property taxes + homeowner’s association dues, if any. For example, if gross (pre-tax) monthly income is $6,000 and your monthly mortgage payment is $1,606.07, to calculate your front-end DTI you divide $1,606.07 by $6,000 resulting in a front-end DTI of 27%.
Back-end DTI takes that same new mortgage payment and tacks all of your other debt on top. To calculate back-end DTI you add all of your monthly debt obligations (minimum credit card payments, car loan or lease payment, student loan payments, etc.) to your estimated monthly mortgage payment and divide the sum by your gross monthly income. For example, assume your credit card minimums and car payment are $1,000 per month – to calculate back-end DTI you take that $1,000 debt + $1,606.07 monthly mortgage payment from above and divide the sum ($2,606.07) by your gross monthly income of $6,000, yielding a back-end DTI of 43%.
Your DTI ratio now looks like this: 27/43. DTI maximums vary depending on the loan program but a good rule of thumb is that neither DTI should be above 43%. There are many programs that will allow you to have higher front and back-end DTIs (Fannie/Freddie, FHA and VA loans for example allow for much higher ratios) but in order to keep your options open and allow yourself the financial flexibility to spend a little money on going out to dinner after you’ve purchased your home, a DTI ratio below 43% is ideal.