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.

Formula
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.

Formula
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%
IV. Savings Strategies

Related Articles
  1. Personal Finance

    Too Much Debt For a Mortgage?

    Just because a lender is willing to offer you a loan doesn't mean you should take it.
  2. Investing

    Debt Ratio

    The debt ratio divides a company’s total debt by its total assets to tell us how highly leveraged a company is—in other words, how much of its assets are financed by debt. The debt component ...
  3. Investing

    Analyze Investments Quickly With Ratios

    Make informed decisions about your investments with these easy equations.
  4. Investing

    Ratio Analysis

    Ratio analysis is the use of quantitative analysis of financial information in a company’s financial statements. The analysis is done by comparing line items in a company’s financial ...
  5. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    Analysts use specific leverage ratios to compare firms within an industry. A basic understanding of these ratios helps when evaluating oil and gas stocks.
  6. Personal Finance

    5 Ways to Up Your Chance of Getting a Mortgage

    Tips and ways to improve your chances of getting a mortgage.
  7. Personal Finance

    Mortgages: How Much Can You Afford?

    The answer involvoes number-crunching as well as factoring in other considerations and expenses.
  8. Investing

    Analyzing AT&T's Debt Ratios in 2016 (T)

    Learn about AT&T Inc. and its key debt ratios, such as the debt-to-equity ratio, interest coverage ratio and cash flow-to-debt ratio.
  9. Investing

    4 Leverage Ratios Used In Evaluating Energy Firms

    These four leverage ratios can help investors understand how oil and gas firms are managing their debt.
Frequently Asked Questions
  1. What Was the First Company to Issue Stock?

    The Dutch East India Co. held an IPO in 1602, making it the first company to issue stock.
  2. When Does a Corporation Decide to Refinance Debt?

    Favorable market conditions or the strengthening of a credit rating may lead to refinancing.
  3. What Is an Odd-Lot Buyback?

    Odd-lot buybacks involve lots of less than 100 shares. Learn how companies get these shares back.
  4. Can I buy a house directly from Fannie Mae (FNMA)?

    Yes, Fannie Mae does sell properties it's foreclosed on; each property is sold in "as is" condition.
Trading Center