When analyzing the personal
budget of a borrower, lenders use two different
debt ratios to determine if the borrower
can afford his obligations. These two debt
ratios are: |
The "top" debt ratio is defined as: |
Top Debt Ratio = Monthly Housing
Expense/Gross Monthly Income |
By "monthly housing expense"
we mean either the borrower's monthly rent
payments, or if he/she owns a home, the
total of the following: |
You will often hear the
term “PITI.” It refers to (P)rincipal, (I)nterest,
(T)axes and (I)nsurance. While PITI is not
exactly the same as Monthly Housing Expense
because it does not include homeowner's
association dues, the two terms are often
used interchangeably.
Lenders have learned over
the years that a borrower's "top" debt ratio
should not exceed 25%. In other words, a
person's housing expense should not exceed
1/4 of his income. While lenders will often
stretch this number to as high as 28%, traditional
lending theory maintains that anyone with
a debt ratio in excess of 25% stands a good
chance of developing budget problems.
The second ratio that lenders
use to determine if a borrower can afford
his/her obligations is the "bottom" debt
ratio. It is defined as follows:
Bottom Debt Ratio
= (Total Housing Expense + Debt Payments)
/ Gross Monthly Income |
The only difference between
the two ratios is the inclusion in the numerator
of "debt payments." Debt payments include
the following: |
What is not included
in "debt payments" is Utilities such as
APS, water or telephone and payments on
real estate loans. Real estate loans are
usually offset first by the net rental income
from the property. If the borrower has a
net positive cash flow from all his rentals,
then the net income is usually added to
his "gross monthly income." If the borrower
has a net negative cash flow from all of
his rental properties, then the amount of
the negative cash flow is usually added
to the numerator of the "bottom" debt ratio
as if it were a monthly debt obligation,
like a car payment.
Traditional lending theory
maintains that a borrower's "bottom" debt
ratio should not exceed 33 1/3%. In other
words, the total of the borrower's housing
expense and debt obligations should not
exceed 1/3 of his income. Lenders often
will stretch on this ratio to as high as
36%, and some have even been known to stretch
as high as 40% or more. Obviously a loan
with a debt ratio of 40% is a far more risky
loan than a loan with a debt ratio of 32%. |