Lenders analyze two different debt ratios to determine whether the borrower can afford his obligations. They are the total Monthly Housing Expense ratio and total Debt to Income (DTI) ratio. Both ratios can also be known as “bottom” or “top”, depending on the customary practices of the lender. The lender may establish guidelines for maximum values for both ratios to help it determine its risk in making a loan. Those guidelines generally change over time and may be flexible; they are only one tool the lender uses to determine a borrower’s credit worthiness.
Both ratios are calculated by dividing the total Monthly Housing Expense amount and the total Debt to Income amount, by the borrower’s gross monthly income.
The total Monthly Housing Expense ratio includes those expenses for the borrower’s primary residence, whether it’s rented or owned. Those expenses, sometimes called PITI, include:
- Principal payments on all mortgages on the borrower’s primary residence, or the monthly rent payment
- Interest included in those mortgage payments
- real estate Taxes
- homeowner’s Insurance
The lender may also include other expenses, such as homeowner’s association dues, if appropriate.
Utility payments for the primary residence are not included in either ratio.
The total Debt to Income ratio includes the total Monthly Housing Expense ratio plus all other regular monthly debt payments. Types of regular monthly debt payments are
- Car payments
- Charge card (revolving) payments
- Installment loan payments
The above list is not intended to be comprehensive; the lender may include other types of regular payments, such as Alimony or Child Support, in the total Debt to Income ratio.
Real estate loans on other investment properties are not normally included in either ratio. Those loan payments are usually offset by the net rental income of all investment properties, either as income if there is a positive cash flow, or expense if there is a negative cash flow.
To verify the payments listed on the borrower’s loan application the lender will obtain a credit report and may request copies of tax returns with all schedules.