Payment and Debt Ratios

Jan 31, 2023 | Mortgage Guides

Payment and debt ratios are financial measures used to assess borrowers’ ability to make on-time mortgage payments on their debts, including housing and other obligations. These ratios help investors, lenders, and buyers evaluate creditworthiness and affordability, which can be the result of extensive research on mortgages and the risk of lending money or extending credit.

‍Resources such as banking advice, tips, and business insights can provide valuable ways to understand the mortgage process, various products, and fees associated with different loan types, such as FHA mortgages.

‍Continue reading below to find out the impact that these essential tools can have on a mortgage application by exploring the content on this page. Property taxes, calculation methods, interest rates, and loan amount considerations can help borrowers make informed decisions on the type of mortgage best suited for them.

Introduction to Payment & Debt Ratios

These ratios are essential in determining creditworthiness. In addition to benefiting the lender, they are necessary for the borrower to secure better loan terms and conditions. Learning the different ratios and how they function can help a borrower qualify for a mortgage with favorable rates.

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Calculating Payment & Debt Ratios

Payment-to-income ratio (PTI) and debt-to-income ratio (DTI) are the standard financial criteria to evaluate an individual’s ability to make mortgage payments and assess their debt level compared to income. This includes aspects such as mortgage payments and housing-related expenses, which determine a buyer’s eligibility for loans.

DTI and PTI are used interchangeably in most circumstances, and both consider DTI ratios as a crucial factor. The only difference between the two is what part of income and debt they calculate. PTI appraises based on off-debt payments and gross income, whereas DTI estimates based on total debt and annual earnings.

‍To calculate PTI, divide the total debt by gross income. For example, let’s calculate the payment-to-income ratio for a person who makes $3,000 per month and has a car loan payment of $400. PTI = $400/$3,000 = 13%.

Understanding Payment & Debt Ratios

These ratios are important factors when measuring a borrower’s finances. Payment and debt ratios come in 5 types, each analyzing a different aspect of finance. The five categories are debt-to-income, debt service coverage, interest coverage, loan-to-value, and credit utilization.

Debt-to-Income Ratio (DTI)

This ratio compares the borrower’s debt to their gross monthly income, considering factors such as housing and other necessities. It assesses the borrower’s ability to manage debt and make timely payments. On a mortgage, creditors often prefer a DTI of 50% or less. The lower the DTI, the better the terms and conditions.

Debt Service Coverage Ratio (DSCR)

The debt service coverage ratio determines the ability to repay debts. It is calculated by dividing the company’s operating income by its total debt service. A DSCR of 1.0 or higher can be considered good, indicating that the company has sufficient income to cover its debt. A DSCR of less than 1.0 indicates that the borrower struggles to make payments and will default on their debts.

Interest Coverage Ratio (ICR)

Similar to DSCR, the interest coverage ratio (ICR) is a financial ratio that measures a company’s ability to pay the interest on its debt. It gets calculated by dividing a company’s earnings before interest and taxes by interest expenses. A higher ICR indicates a greater ability to meet its interest payments.

Loan-to-Value Ratio (LTV)

Lenders use the loan-to-value ratio to express the balance of a loan to the value of an asset, such as a house. It is used when applying for a mortgage and represents the percentage of the total borrowed.

Credit Utilization Ratio

The credit utilization ratio is the credit an individual uses compared to their total credit. It gets calculated by dividing the outstanding credit balance by their available credit.

Keeping the credit utilization ratio low is recommended, as high credit utilization affects the credit score. Lenders see high credit utilization levels as an indication that you are financially stretched or unable to make payments.

What Payments to Include in a DTI?

All debts that have to be paid monthly should be included when calculating the DTI. If you miss something, the lender will provide them. However, enclose all payments in the calculations so you can accurately estimate the DTI.

Common DTI payment factors include mortgage/rent, child support, car payments, student loans, medical bills, timeshare payments, credit cards, and personal loans.

What Payments Not to Include in a DTI?

Regular expenses not considered debt do not have to be included in the DTI calculations. These payments consist of utilities, trash disposal, auto insurance, cellular data, and cable bills.

Does the DTI Ratio Affect My Ability to Get a Loan?

Creditors use DTI to determine whether you can take on additional debt. A high DTI is a red flag because it indicates that making payments on top of existing obligations may be difficult. That makes it more challenging to secure a loan at desirable terms.

A low DTI suggests you have the income to make the loan payments. It makes getting approved and securing a better interest rate easier. Click here to read more about financial considerations for first-time home buyers.

What is a Good Debt-to-Income Ratio?

A DTI of 36% or less is considered good. However, lenders may accept a higher DTI if a strong credit score and other positive factors in the credit history accompany it. Remember, when it comes to DTI, the lower, the better.

What Does a Debt-to-Income Ratio of 1.5 Signify?

A debt-to-income ratio of 1.5 means that the monthly debt payments equal 1.5 times the gross monthly income.

Can I Have a Negative DTI?

No. The lowest possible DTI is 0%. That is because one cannot accrue less than zero debt. It is best to have the lowest DTI possible.

Debt Ratio vs. Long-Term Debt to Asset Ratio

The debt ratio measures the company’s debt relative to its assets. It gets calculated by dividing its total debt by its total assets. A high debt ratio indicates that a company has a lot of debt relative to its assets, which implies it is in a risky financial position.

The long-term debt-to-asset ratio measures a company’s long-term debt compared to its assets. It is similar to the debt ratio. However, it does not consider short-term debt payments.

Bottom Line

Debt ratios are essential tools for creditors and borrowers alike to determine the creditworthiness and risk of failure for individuals and businesses. It is prudent to aim for the lowest debt ratio possible, between 0 and 36.

Wesley Mortgage can answer your questions and provide more information about home-buying, mortgage rates, and the number of available options for prospective homeowners. Engaging in thorough research is crucial in ensuring a successful home-buying experience.

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