What are debt ratios and how are they calculated?

Your debt-to-income ratio (or DTI) is a simple calculation comparing your gross monthly income to your new housing expense and your total other expenses.

For a simple illustration, let’s take a W2 borrower earning $60,000 in salary. That is equal to $5,000 per month. Let’s assume their mortgage payment is $1,750/month, and they have a $500/month car payment, $100/month student loan payment, and a $50/month minimum payment on a credit card.

Their front-end or housing ratio would be the $1,750/month payment divided by the $5,000 in income resulting in a front-end ratio of 35% ($1,750/$5,000).

To calculate the back end or combined ratio, we add up the $1,750, $500, $100, and $50 to get a total of $2,400/month in monthly payments leading to a ratio of 48% ($2,400/$5,000).

There are a few things to consider when calculating debt-to-income which may lead different banks and underwriters to come up with different ratios for the same borrower.

For example:

Alimony expense: Using the same scenario above, let’s say that a borrower has a $500/month alimony payment that needs to be accounted for. There are 2 ways to calculate this:

A: Subtract it from income and you would get $2400/$4500 or a ratio of 53.33%

B: Add as a liability and you would get $2900/$5000 or a ratio of 58%

Additional income/loss: Let’s say you do some woodworking as a hobby and sell the picture frames you make on Etsy®. You sold $1,000 worth of products and your cost of goods sold was only $500. This gave you a net profit of $500. However, you have $500 in home internet expenses, and you bought a new laptop for $1,000 that your CPA says you can deduct. You now have a $1,000 loss reporting on your schedule C income. Some banks would ignore the loss (treating it as a hobby) while others would reduce your income (treating it as a second job).

Self-Employed income: Income received by self-employed borrowers can be difficult for underwriters to calculate. We have had a handful of clients who were denied by other lenders because of significant depreciation expenses. In one instance, we had a successful business owner who is considered a qualified real estate professional (click here to learn more about QREPs). He and his partner owned a large office complex and did a “cost segregation” study (click here to learn more about cost segregation). They were able to write off a significant amount of losses to offset their business income. In fact, the client showed a loss on his taxes. However, because we were able to add back the depreciation, they got approved for a conventional mortgage.

In instances where conventional mortgage is not an option, we have bank statement loans as well as DSCR loans for real estate investors.

Same borrowers, same numbers, different underwriting guidelines and that could make or break a deal.