Most people are familiar with credit scores and know that they’re a measure of credit quality. But do you know what it actually is? You may be surprised, but your credit score actually doesn’t consider your income. It just predicts how well you’re likely to continue to make payments based on your current debt level and past payment history. Because of the way it’s calculated, it doesn’t attempt to predict how much debt you can afford to pay back based on your income.
To calculate whether your debt level is affordable, lenders use different metrics that compare your debt and other financial obligations to your income. Front-end and Back-end Debt-to-Income (DTI) ratios are two that are frequently used by mortgage lenders as an indicator of your monthly financial health. The names sound intimidating, but they’re just ratios that compare your fixed monthly debt payments and other financial commitments to your monthly income to give lenders a sense for your ability to pay off your debt over time. If your DTI levels are high, it means that a large portion of your income is going to cover your debt obligations and, as a result, you have a higher likelihood of not being able to manage your payments over time.
Understanding Your Income
Lenders take a holistic view of your income and include many factor that you may not immediately think of it when you think of your monthly income such as alimony, child support, social security payments, income from a second job (if you have had this source of income for at least two years), and investment income. Generally, lenders will take you annual income and translate it into a monthly figure.
Front-End DTI (Housing Debt)
Front-End DTI is a measure of your ability to afford your current or proposed housing. The mortgage lending guideline has traditionally been 28%. The US Government considers 30% to be the point at which housing begins to be unaffordable. So how is it calculated?
The front-end ratio is calculated by comparing the ratio of monthly housing expense to your gross (pre-tax) monthly income. The monthly housing expense consists of principal, interest, property taxes, and insurance (PITI). Since many housing choices have mandatory homeowner’s association dues and mortgage insurance, these amounts are added to the PITI to calculate the complete front-end DTI ratio.
What is a healthy front-end DTI?
Compare your DTI to the table below:
| <28% | 28% has been the traditional “safe” limit for bank lending and is a highly manageable housing debt load. |
| 28-30% | 28% has been the traditional “safe” limit for banks and 30% is the point at which the US government considers housing to start to be a risk. |
| >30% | Above 30%, the expense ratio is such that the homeowner is at higher risk of default. Many private mortgage lenders increased Front-End lending standards to 33% during the mortgage boom. |
Back-End DTI (Total Debt Health)
The second measurement that lenders use to assess a lender’s health is the Back-End ratio, which is a comparison of your total monthly debt payments (PITI plus other monthly debt payments AND all of your other debt and fixed commitments) to your gross monthly income. This measurement captures all recurring obligations beyond those attributable to housing (PITI + association dues and mortgage insurance). This includes traditional debt such as credit card debt payments, auto loans, student loans, medical debt, and other loans. But it also includes other fixed obligations such as auto leases, child support, alimony, judgments, and other monthly obligations.
When computing this ratio, lenders look at the long term and generally only consider your obligations that will still exist after 6-10 months.
So what’s healthy? Traditionally, lenders consider a Back-End ratio less than 38% as manageable and healthy. How are you? Compare your ratio to the table below:
| <32% | This is a highly conservative debt load for most people and should be highly manageable, with very little risk to your broader financial goals. |
| 32-36% | This is a very manageable debt load for most people and is generally considered very manageable by lenders. With this debt load, there is little risk that these commitments will become unmanageable. |
| 36-42% | This level of financial commitment may be manageable in the short run, but can put you at risk over the longer term. Work to reduce your debt load to the lower end of this range by paying off credit card and other debt as rapidly as possible. |
| 42-49% | This debt ratio is high and could indicate future financial difficulty if you don’t take immediate action. Pay off credit card and other obligations as quickly as possible to improve your financial condition. |
| >50% | At this level, you may have to consider immediate drastic action to move to a safer zone. Pay off credit card and other obligations as quickly as possible to improve your financial condition. If you feel that you cannot make headway against your debt with your current resources, see help from a qualified credit counselor. At this level, you may also have to consider options such as debt settlement or bankruptcy. |
Summary
As with everything, the front-end and back-end DTI metrics are relative. If you don’t have consumer debt such as credit card and auto debt, you may be comfortable with a higher front-end DTI. If you have children and anticipate the costs of children and college educations, you may wish to keep your debt ratios lower than a couple that does not anticipate having children. Finally, if you are older and anticipating retirement, you may wish to have lower DTI ratios than someone younger who has longer to pay off their debt.
As with many things in life, there are no absolutes and your comfort level may depend on factors. But in this case lower is always better, so aggressively work your DTI ratios down to a comfortable level.
Scott Crawford is CEO of DebtGoal.com, a do-it-yourself system for getting out of debt and lowering your interest costs. DebtGoal.com incorporates all of the techniques discussed in this post and can help users understand and get visibility to and manage their debt finances.
Tags: debt health, DTI
