Debt-to-income (DTI) ratio is a crucial calculation that compares what you earn to what you owe. Lenders (like banks or mortgage companies) use your debt-to-income ratio to decide whether to grant you credit and how much. Lenders often distinguish between borrower front-end and back-end ratios.
What Is the Difference Between Front- and Back-End Debt Ratios?
The front-end ratio compares a person's monthly mortgage or rental expenses to their gross monthly income. Debt includes mortgage principal and interest, property taxes, insurance, and HOA (homeowners association) fees, if applicable. The income portion typically does not include anticipated bonuses or overtime payments. A satisfactory front-end ratio is 0.28. For example, suppose you have a gross monthly income of $10,000 and monthly housing costs of $3,000. The front-end ratio would be 0.30, slightly higher than an acceptable front-end ratio. Instead, assume that income is $12,000 monthly, resulting in a front-end ratio of 0.25, which is within accepted limits.
In reality, the back-end debt-to-income ratio may be a more critical factor in a lender's decision whether to offer financing. This is because the back-end debt ratio adds other monthly obligations to the total. For example, the calculation includes credit card payments, student loans, vehicle loans, and alimony or child support obligations. In this case, the preferred maximum ratio is 0.35. If your percentage is higher than that, you can most likely find a loan product, as long as you have other positive factors like good credit and a down payment.
Is a Rental Property Helping or Hurting My DTI Ratio?
The financial impact of your investment property affects both sides of the DTI calculation. The mortgage obligation contributes to your debt expenses, and income is partially eligible for inclusion. Typically, lenders will calculate income using only 75 percent of the average rent. To illustrate, suppose you own a rental property with monthly expenses of $1000 and an average rent of $1,500. You can add $1,125 to the income side and $1,000 to the debt side of your ratio calculation.
Suppose you have other income of $5,000 for a total of $6,125. In that case, your other expenses should be lower than $1,143 to maintain a back-end debt-to-income ratio of .35. However, with a higher down payment and an excellent credit score, investors may qualify for financing on a multi-family property with debt-to-income ratios as high as fifty percent.
How Can I Reduce DTI?
One important tool for reducing your debt-to-income ratio is to pay down debt or, if possible, refinance at lower interest rates. Suppose the rental property is a small portion of your overall financial picture. In that case, you may want to focus on changing other areas, like vehicle loans or credit card balances. If the rental income accounts for a large portion of your ledger, consider improving the property or making other changes. The ratio can change with additions to income or reductions in debt.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Examples are hypothetical and for illustrative purposes only. Withdrawal strategies should take into account the investment objectives, financial situation and particular needs of the individual.
