Financial Statements - III. Debt Management Ratios
Standard financial ratios are used to evaluate one's financial condition. Debt management ratios, in particular, are used by banks and other lenders to evaluate a prospective borrower's suitability for a home mortgage or other loan.
A variety of different debt-to-income ratios are key indicators of an individual's financial health. In general, the debt-to-income ratio is calculated by dividing monthly minimum debt payments by monthly gross income.
Debt-to-Income Ratio = Monthly Debt Payments/Monthly Gross Income
There are three common variations of the debt-to-income ratio. They measure consumer debt, housing debt and total debt.
A. Consumer debt
The consumer debt ratio compares nonhousing debt to monthly income. For example, someone with a gross monthly income of $5,000 paying $600 per month toward credit card balances and auto loans would have a consumer debt ratio of 12%.
$600/$5,000 = .12 or 12%
A consumer debt-to-income ratio of 10% or less is considered excellent.
B. Housing costs
Lenders considering an application for a home mortgage traditionally look at what an individual's or family's debt-to-income ratio for housing-related expenses would be. The monthly housing expense includes principal, interest, property taxes and homeowner's insurance, also known as PITI. Homeowners' association dues and mortgage insurance also are considered if applicable.
This measurement of monthly housing costs against income is known as the front-end ratio.
Front-End Ratio = Principal, interest, taxes and insurance/Monthly gross income
For example, a borrower with an annual income of $48,000 with a monthly PITI payment of $1,200 would have a front-end ratio of 30%.
$48,000 annual salary/12 months = $4,000 a month.
$1,500/$4,000 = .375 or 37.5%
Different borrowers use different standards with regards to an acceptable front-end ratio. One bank, for instance, may require a front-end ratio of no more than 33%. Another may place the limit at 35%.
C. Total debt
Lenders also calculate the total monthly debt-to-income ratio of potential borrowers. This is known as the back-end ratio. This includes both consumer debt and monthly housing payments.
Total monthly debt includes expenses such as mortgage payments (made up of PITI), credit-card payments, child support and other loan payments. Lenders use this ratio in conjunction with the front-end ratio to approve mortgages.
For instance, a borrower with a monthly income of $6,000 and total debt and monthly housing payments of $1,800 would have a back-end ratio of 36.8%.
$2,200/$6,000 = .368 or 36.8%