Debt to Income Ratio
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The formula for the debt to income ratio is the applicant's monthly debt payments divided by his or her gross monthly income.
The debt to income ratio is used in lending to calculate an applicant's ability to meet the payments on the new loan. The debt to income ratio may also be referred to as the back end ratio specifically when a new mortgage is requested. The term back end ratio, or total debt to income, is used to differentiate the calculation from the housing debt ratio, also called the front end ratio.
Whether it is bonds, stocks, or any other form of investment, measuring the ability of the individual or company to remain solvent is important. For a lending institution, loans are an investment which generally comprises a very large portion of their investment portfolio. For a financial institution, calculating the debt to income ratio is similar to a potential bondholder evaluating a company's debt load before deciding to invest.
Debt to Income and the C's of Credit
The 3 main "C's of credit" are character, capacity, and collateral. Character specifically relates to the credit report and collateral relates to the loan to value formula. Capacity, meaning the capacity to repay, is determined by the debt to income ratio.
Use of Debt to Income Formula
The debt to income ratio is used with consumer loans, credit cards, and mortgages by underwriters, loan officers, and sometimes other employees at financial institutions. Each financial institution has a set of guidelines for loan to value, debt to income, housing debt, credit, and other measures that are used by the employees who are reviewing loans.
As an example of evaluating the debt to income ratio, a very general guideline for mortgages in recent times may show 28/36, which means that the housing expense can not be more than 28% and the total debt to income can not be more than 36% of gross monthly income. The housing expense generally will include homeowner's insurance, property taxes, PMI, flood insurance, home owner's association fees, or any other expense directly associated with housing. The total debt to income will generally include any monthly debt obligation and lending institutions will have different guidelines on which additional expenses will be included and what payment will be used(e.g. credit card payments).
- Formulas related to D/I
- Loan to Value (LTV)
- Debt Coverage Ratio
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