How to Calculate a Debt to Income Ratio
Figuring your debt to income ratio can be tricky. Most wage earners and salaried employees will breeze through this section, however if your commissioned or self employed you may want to pay close attention to this section.
When underwriters figure your debt to income ratio (DTI) they will use the same methods from lender to lender as it pertains to conventional mortgages. Below are a few rules when making these calculations. For this exercise we highly suggest that you have a copy of you credit bureau in hand.
- All income is calculated as gross income. (before taxes and deductions)
- All payments used are calculated from the minimum payment
- Child support is treated as an expense if you pay it*.
- Child Support can be treated as an income if you receive it for the next 3 years*.
Calculating Gross Income
All earnings calculations are pretty straight forward, however there are some assumptions and rules you need to be aware of:
- All income is analyzed two years prior to present and averaged.
- If current income is higher, it must be permanent and expected to last at least two years.
- Temporary income, seasonal income and part time jobs are not counted as income unless there is a two year history of that income stream.
- Overtime income is not used unless there is a steady pattern of overtime in the past and the employer acknowledges it is likely to continue.
- Self employed borrowers must produce two years of business and personal tax returns and sometimes a profit and loss statement for the year to date.
- 100% Commissioned borrowers must produce two years of W2′s from the same line of work and they will be averaged with a year to date pay stub.
- Child support, Social Security and untaxed pension income may be “Grossed Up” meaning that this income is non taxable and may be increased by 25%. ($1000 x 125%= $1250)
- *Child Support may only be counted if it proved to last for the next three years.
Formulas & Ratios
Debt to income ratios have become somewhat ambiguous due to today’s automated underwriting. Conventional mortgages are almost always underwritten by one of three engines. Desktop underwriter, Desktop Originator or Loan Prospector.
These engines evaluate your whole credit situation not just your DTI as in the manually underwritten days.
I have had borrowers with DTI ratios as high as 65% get an automated approval based on low loan to value, good credit and an abundance of assets.
If you have a high debt to income ratio and these other compensating factors are not present you should consider doing a reduced documentation loan.
FHA used to be the standard for debt to income ratios. They divide the ratios into a front and back ratio. The front ratio consisting only of your total mortgage debt divided by your gross income. Then your total debt divided by your gross monthly income.
Most FHA loans are still manually underwritten and their guidelines say your ratios must be 31% on the front and 43% on the back. A good rule of thumb for most conventional mortgages is to be around 45% total debt to income ratio. (Total debt divided by total gross income)
Monthly |
|
| Salaried Earners |
Last two years of W2 statements add together then divided by 24 = GMI |
| Hourly Earners | Hourly Rate multiplied by 40 then by 52 then divided by 12 Plus overtime. Overtime that is regularly worked – Hourly wage multiplied by 1.5%. Average hours of overtime worked each week multiplied by 52 and divided by 12. Add to first calculation = GMI |
| Salary Plus Commission | Salary for last 2 years W2′s is averaged separately from commission, then commission is averaged for the year to date. (Salary x 2 divided by 24 = GMI salary) PLUS (Commission YTD / current month then added to salary GMI) |
| 1099 Contract | A written verification of employment and two years of the exact type of contract work. These borrowers are treated as self employed and usually must produce tax returns for conventional mortgages. Tax returns adjusted gross income less schedule “C” deductions plus schedule “E” depreciation = GMI |
| Tips and Hourly | W2′s from previous two years are averaged. (W2 x 2 /24 = GMI) Most borrowers working for tips do not claim all their tips and will need to use a reduced doc type. |
| Fixed Income | Fixed income is income that is fixed by another entity and will last for at least two years from the date of closing. If income in this category (SSI, Army Pensions, Child Support) are not taxable you may increase this income by 25%. (Income x 125% = GMI) |
| Self Employed | 90% of all self employed will need to use a reduced documentation loan. Borrower must have 2 years of self employment, so the prior 2 years tax returns for the business and personal are analyzed to determine income. (Adjusted gross income x 2 / 24 – Schedule C & E deductions + earned depreciation) Then personal taxes are done the same way then averaged with the business taxes. |
