The debt-to-income ratio compares income to debt for a given period, useful for budgeting and assessing a borrower’s ability to take on additional debt. There are two types: front-end and back-end, with lenders setting a percentage range for approval. Variable charges must be disclosed.
The debt-to-income ratio is a simple comparison between the income generated over a given period and the amount of debt that must be serviced during the same period. A debt-to-income ratio is usually calculated for a period of one month, providing a snapshot of what needs to be earned to pay the monthly obligations. Debt-to-income ratios are useful for determining how much additional debt can be taken on without creating financial hardship.
Understanding the relationship between debt and income is helpful in many different ways. For people attempting to develop a workable monthly budget, it is important to identify all current obligations and the type of monthly payment required to keep debts in good standing with creditors. For lenders, getting a true picture of the debt-to-income ratio helps assess a borrower’s ability to take on additional debt.
There are actually two distinct forms of the debt-to-income ratio. The first is known as front-end or high debt-to-debt ratios. This report involves comparing your monthly gross income to your monthly housing expenses. While not a complete picture of monthly debt obligations, this approach demonstrates whether the borrower can continue to afford housing if an additional loan obligation is added to the mix.
The back end or low debt-to-income ratio focuses on adding up all your fixed monthly expenses to get your total monthly obligations and comparing the total to the monthly gross income amount. In addition to basic housing obligations, debts such as monthly child support, health insurance payments, credit card payments, and alimony are also considered. This approach to determining the borrower’s true financial status provides a clearer idea of the total current debt load and gives the lender a better idea of how much risk is involved in extending the loan.
It’s important to note that calculating a debt-to-income ratio will always include all obligations that appear on a credit report. This means that there will be existing loans and other fixed monthly expenses. However, variable charges are unlikely to be listed on a credit report and therefore must be disclosed by the borrower.
Lenders also tend to set a percentage range for the debt-to-income ratio. When the debt-to-income ratio calculator indicates that the front-end ratio is no more than 35% of gross income and the back-end ratio is no more than half of gross income, the borrower is generally considered a good risk. However, if the debt-to-income ratio is more than 50%, lenders can reject the loan application.
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