The definition of Debt To Income Ratio (aka – DTI), is a term and/or a calculation used by institutional and private lenders to identify a borrower’s overall financial situation pertaining to debt and the income that comes in on a monthly basis.
Simply put, a borrower’s debt-to-income is the relation between what you owe and what you make. To calculate a borrower’s DTI ratio, a lender or underwriter would take the borrower’s monthly debt payments (such as house, credit card, and payments) and divide it by your monthly take-home income.
EXAMPLE OF A DEBT-TO-INCOME CALCULATION
Let’s assume a borrower earns $6,000/month which would be considered their over-all gross monthly income. If that same borrower have a car payment of $600/month and a house payment of $1,500/month, total credit card payments of $175/month and a motorcycle payment of $375/month, when you add these monthly amounts together, the end result is your monthly debt/fixed expenses.
To establish a borrower’s debt-to-income ratio, divide their monthly debt payment by their monthly income. The end result is your debt-to-income ratio.
Monthly Income: $6,000
Total Monthly Debt Payment: $2,650
Debt to Income Ration = $2,650 / $6,000 = 44%
After the lender calculates the borrower’s debt-to-income ratio, it’s time to discover what the ratio is showing us. If a ratio of 10% to 20% or less, it means the borrower has an excellent debt-to-income ratio. This means that the borrower’s over-all monthly income is significantly higher than what they owe in outstanding debt.
That being said, if the borrower has a debt-to-income ratio of 35% to 39% or higher, it means that the borrower is taking on too much debt in relation to their income, in the eyes of most traditional lending institutions.
After the Sept 2008 banking crash and national capital freeze, anything over 35% to 39% is considered risky since it will be difficult to continue to cover your monthly debt obligations with your current income (pertaining to residential mortgage loans).
Prior to the 2008 banking melt-down the average accepted DTI was 45% to 55% (a huge difference).
Most lenders and banks are even more stringent when deciding a commercial mortgage loan which typically requires a 27% to 32% DTI according to most national chain-banks such as: Wells Fargo, Chase, etc.
DEBT-TO-INCOME RATIO AND LENDERS
Most institutional lenders as well as some private lending sources calculate and analyze a borrower’s debt-to-income ratio to determine the size mortgage that the borrower can afford. In fact, a borrower’s DTI, credit score and the borrower’s loan-to-value (LTV) are frequently the most important numbers that any lender looks at when quoting a mortgage amount and interest rate (for loan origination or loan refinance).
HOW THIS AFFECTS NOTE SELLERS
This is why it is highly suggested to always pull the borrower’s credit report when creating a mortgage note or creating a business note for resale to a note investor. In addition, this also pertains to note sellers that have included a balloon payment (which we do not suggest in this economy) when structuring a note for resale to a buyer.
Keep in mind that if you as the note seller are relying on a balloon payment to be made after creating a note, the bulk of the return on investment hinges on the borrower being able to be refinanced by a regular bank or lending institution. In this sad economy, this is unlikely to happen if the borrower’s DTI is higher than 30% to 40% depending on the loan amount credit score and loan terms.