Mortgages Explained – Debt Service Ratio

By Douglas Katz – 06/30/2022

So everybody is talking about rates.  Clients call me and that is their first question, especially in the current environment, but oddly enough it is not the rate that matters.  It is the payment.  I know that a comment like that has the ring of a used car salesman, but nothing can be further from the truth.  I bring up payment because rate is actually not even mentioned in most loan product guidelines.  Other than laying out the specific terms on something like an Adjustable Rate Mortgage (ARM), loan guidelines always center on the payment.  This is where the Debt Service Ratio or Debt-to-Income Ratio (DTI) comes into play.   This calculation is the analysis of whether you can make the payment based on your current income and your debt, to include the new home.

Before getting into how the ratio is calculated and how it impacts you, you first need to understand the regulations and requirements placed on lenders.  While there are some programs outside the regulatory requirements, most loans have a requirement that the lender confirm and document that the borrower has an ability to repay the loan.  It is in fact called the ability to repay and it because a major focus after the housing crisis of 2008.  Prior to that, rules were a bit more lax and you can see where that got us.  Now , the borrower must unquestionably have the means and capacity to repay the loan.  This is reflected in their debt service ratio, which will generally have ceiling that a borrower cannot exceed.  Even with some of the aforementioned niche programs that are not highly regulated, lenders will set a number that fits their risk appetite, so the need to prove ability to repay will still be relevant.  You just may have more flexibility in maximizing income.  So, hopefully now that is is clear that the debt service ratio is a measure of your ability to repay a loan, let’s go into the deep dive.

The debt service ratio is generally calculated by taking all sources of documentable income and determining a ratio based on your debt.  While seemingly simple, this is not always easy.  The math is undoubtedly simple, but determining the numbers used in the math is not.

  • DEBT – The debt part of the equation is ALL of your debt to include cosigned and joint debt.
    • The numbers will be initially taken from your credit report as that is the most easily obtained and commonly accepted documented reflection of your debt.
    • Changes for items like student loans that may have a default number that does not match the actual payment are allowable, but you need to provide documentation to supersede the credit report.  This goes for items like closed accounts, credit lines that have been paid down or any other inaccuracies as well.
    • You can also omit payments that are paid by someone else, but expect to provide proof that the person paying the debt has done so for 12 or more months with checks, bank statements, or creditor statements.
  • INCOME – Income is a bit more flexible and while you can use all sources of income for all borrowers, some borrowers choose to only use income relevant to qualifying.
    • W-2 income is fairly simple and documentation is as you would expect a W-2 and some paystubs.  If there is any variability to your income, expect to provide enough documentation to show that it is predictable.  The typical hurdle is a 2-year history, so if you are new to the workforce, going through a career change or re-entering the workforce due to a divorce or something similar like empty nest scenario, you may be unable to use what you consider your full income.
    • Self-Employed borrowers need to be ready for a significant paper chase.
      • Expect the same 2-year hurdle as above with full business and personal returns.  The lender, unless using a niche program for self employed borrowers, will not be able to massage numbers to match your income if you are adept at working the tax code.  You saved money on taxes, but you cannot have your cake and eat it too by using a different number.  That is not to say that there are minor differences, but I have clients tell me that they make six figures and they report five figure income.
      • This also applies to rental income on investment properties.  I have innumerable who have come to me with rental properties that they rent out but do not report on their taxes.  If this is you, repeat after me “I cannot use the income.”  It does not matter if the tenant pays on time.  If not documented, the income does not exist.
    • Other sources like disability, child support, maintenance and social security are absolutely allowable.  All have their own documentation requirements, so check with your lender.  In general however, any source would optimally have 6 months history and 36 months continuance.

So once you have the numbers, the ratio will be calculated in two forms – FRONT-END and BACK-END.

  • FRONT-END – The ratio of your income to the payment for the property you are financing.  (Example Below)
    • Income – $60,000 or $5,000/month
    • New FULL payment – $1,500/month
    • FRONT-END RATIO – $1,500/$5,000 = 30%
  • BACK-END – The ratio of your income to ALL of your debt. (Example Below)
    • Income – $60,000 or $5,000/month
    • ALL Debt Payments – $2,500/month
    • FRONT-END RATIO – $2,500/$5,000 = 50%

Once calculated, your lender will compare your ratios to the allowable ratios for the program that you want to use for financing the home.  If it is less than or equal to the allowable ratios, you’re likely to get approved.  Right now 43% back-end is a good rule of thumb, but some programs are more flexible with compensating factors.  If too high, you may need to restructure the deal to get below the allowable tolerances.  When this cannot be done, the loan would be denied.

So that is it in a nutshell.  The important thing for you to remember when applying is that the numbers that go into the calculations are what is important.  If you are playing around with mortgage calculators, that is fine, but make sure that your assumptions are correct.  I actually feel that this is too vital to DIY because of the huge possibility of errors.  You will be using a lender at some point anyhow and they will do this for you at no cost, so why not do it early in the process,