Cartoon character drawing of man standing on a beam holding a bag labeled debt in one hand and a bag labeled income in the other hand

Understanding Debt to Income Ratios

When we think of our financial health, we often think of our FICO or credit score. However, there is another very useful and telling metric known as debt-to-income ratios (DTI). DTI ratios are a measure of monthly debt payments divided by monthly income. Depending on the particular DTI ratio being calculated, either monthly gross income (before taxes) or net income (after taxes) is used.

Generally speaking, there are 3 different types of debt and their corresponding DTI ratios. The first is known as consumer debt, this is typically debt that is used to buy near term goods and services. As examples, this could include credit card debt, auto loans and personal lines of credit. This ratio is calculated by taking monthly debt payments and dividing by monthly net income. The second is known as housing debt (or costs). This ratio is also known as the front-end ratio. This would include the total monthly rent payment mortgage payment including principal, interest, taxes, insurance and mortgage insurance if applicable. This ratio is calculated by taking monthly housing cost and dividing by monthly gross income. Lastly, there is total debt, this is simply the combination of both consumer and housing debt. This ratio is also known as the back-end ratio. This ratio is calculated by taking both consumer debt and monthly housing costs and dividing by monthly gross income.

There are general debt management rules of thumb that can be helpful in measuring DTI ratios and predicting financial strain. Consumer debt should be kept at a DTI ratio of no more than 20%. Housing costs, the front-end ratio, should be no more than 28%. Lastly, total debt, the back-end ratio, should be no more than 36%.

How do these DTI ratios translate into a picture of financial health? Studies have shown that significantly drifting and staying above these ratios can be a sign of financial strain. Such strain has the potential to crowd out the ability to meet other financial obligation such as food, utilities, childcare, vacation, savings, etc.

When it comes to qualifying for a mortgage, lenders weigh these DTI ratios heavily when considering the credit worthiness of a borrower. Lenders will typically be most concerned with both the front-end ratio and the back-end ratio. Mortgage lenders are bound by the ability-to- repay rule. Under this rule, the lender must make a good faith effort to ensure that given the amount borrowed and the interest rate, the borrower has a reasonable ability to make the loan payments. They want to have a reasonable expectation that a mortgage along with other debt servicing is not going to put financial strain on the borrower.

The housing challenge in our region is no secret. According to the Mountain Housing Council of Tahoe Truckee, the median home price in our region was $702,000 in 2020¹. That pricing has likely climbed given residential influx we’ve experienced due to COVID-19. By comparison, the 2019 Local Area Median Income (AMI) for a family of 4 was approximately $84,000². By keeping housing costs at or below 28% of gross income, this AMI supports a monthly payment of approximately $1960. This monthly payment would not support a mortgage on a home with the median price shown above, even with a significant 20% down payment.

Put me in the camp that believes our local housing market will correct from the current stratospheric levels. It will likely take a bit of time for a reversal and nobody knows exactly what might cause it. While we await the arrival of this reversal, I believe there is an opportunity. To take advantage of this time, look at aggressively paying down consumer debt. This has two enormous benefits, first, it increases the capacity to afford more house by allowing more of the total DTI to be dedicated to housing costs and less to consumer debt. Secondly, paying down consumer debt has the ability to positively impact your FICO score. This is because the largest contributors to a FICO score are on-time payment history and low outstanding balances compared to credit available. These 2 items account for approximately 65% of our total credit score. Lastly, as debt obligations begin to fade, this frees cash flow to possibly save for that all important down payment.

This article is meant to be general in nature and should not be construed as investment or financial advice related to your personal situation. Please consult your financial advisor prior to making financial decisions.