What Are Qualifying Ratios?
Qualifying ratios are measuring devices that banks and other financial institutions use in their loan underwriting process. An applicant's qualifying ratio, expressed as a percentage figure, plays a key role in determining whether they'll be approved for financing, and often for the terms of the loan as well.
Lenders use qualifying ratios, percentages that compare a borrower's debt obligations to their income, in deciding whether to approve loan applications.
- The debt-to-income ratio (total expenses divided by gross income) is used in underwriting personal loans, credit card applications, and mortgages.
- The housing expense ratio (housing-relating expenses divided by gross income) is used in underwriting mortgages.
- While each lender sets its own qualifying standards, what's generally desirable is a debt-to-income ratio of 36% or less, and a housing expense ratio of 28%.
How Qualifying Ratios Work
Qualifying ratio requirements can vary across lenders and loan programs. They are often used in combination with a borrower’s credit score in evaluating an application.
When it comes to consumer financing, the debt-to-income ratio and the housing expense ratio are two of the most common and significant qualifying ratios. Standard credit products (personal loans, credit cards) will focus on a borrower’s debt-to-income ratio. Mortgage loans will use both the housing expense ratio and the debt-to-income ratio.
Online lenders and credit card issuers often use computer algorhythms in their underwriting process. This automated system often lets loan applications be approved in minutes.
Qualifying Ratios in Personal Loans
In the underwriting process for all types of personal loans and credit cards, the lender will focus on two factors: the borrower's debt-to-income ratio and their credit score. The two are usually given equal weight.
The debt-to-income ratio (DTI), which may be calculated monthly or annually, considers a borrower’s current, regular debt obligations against their total or gross income—comparing how much they have outgoing, vis-a-vis the regular amount they have coming in, over the same period. To obtain the ratio, you divide the outstanding debt payments by the total income. Or, as a formula (assuming the more common monthly calculation):
While each lender has its own specified parameters for loan approval, high-quality lenders generally will require a debt-to-income ratio of approximately 36% or less. Subprime and other alternative-financing lenders may allow for debt-to-income ratios of up to approximately 43%.
Qualifying Ratios in Mortgage Loans
Mortgage loan underwriting analyzes two types of ratios along with a borrower’s credit score. Mortgage lenders will look at a borrower’s housing expense ratio; they will also consider a borrower’s debt-to-income ratio.
In mortgage financing, the housing expense ratio is also referred to as as the front-end ratio while the debt-to-income ratio is often known as the back-end ratio.
Housing Expense Ratio
The housing expense ratio is generally a comparison of the borrower’s total housing-related expenses to their gross or pre-tax income. Lenders have numerous expenses that they may consider when determining an applicant's overall housing expense ratio. They usually focus on the mortgage principal and interest payments; however, they may also look at other regular costs, such as homeowners and hazard insurance, utility bills, property taxes, homeowners association fees, and mortgage insurance. The sum of these housing expenses is then divided by the borrower’s income to arrive at the housing expense ratio; the figures can be calculated using monthly payments or annual payments.
Underwriters use the housing expense ratio not only to grant approval for the mortgage, but also to determine how much principal an applicant is eligible to borrow. Most lenders typically require a housing expense ratio to be approximately 28% or less. A higher housing expense ratio may be acceptable based on compensating factors such as a low loan-to-value ratio for the property, and/or an excellent credit history for the borrower. The realities of the local real estate market may play a part too: In expensive regions such as New York City or San Francisco, it's not unusual for housing expenses to total one-third of people's income.
The debt-to-income ratio in mortgage loans is the same measure used in personal loan products. Lenders generally also look for a debt-to-income ratio of 36% for mortgage loans as well. Some government-sponsored loan programs may have looser standards for debt-to-income: Fannie Mae accepts debt-to-income ratios of approximately 45% for the mortgages it backs, and Federal Housing Administration loans accepts debt-to-income ratios of approximately 50%.