In the vocabulary of real estate, various ratios help buyers and mortgage services determine the viability of a purchase. A ratio is a way of expressing the relationship between two values or amounts. Usually, ratios compare how much of one thing there is in relation to another such as a 20 to one student-to-teacher ratio. Expressed as 20:1 or 20/1, it means that on average, there are 20 students for every one teacher. In real estate, there are many sets of ratios used to determine the value of a purchase or sale. Different ratios apply to homebuyers, investment property buyers, sellers, and mortgage lenders. Since ratios are guidelines that can make or break a deal, knowing how ratios affect you and how you can control them will make your real estate transactions smoother. Three that apply to homebuyers are the debt-to-income ratio, the loan-to-value ratio and the price-to-income ratio.
Debt-to-Income Ratio (DTI)
The most important ratio to homebuyers is the debt-to-income ratio. Also called the debt-service ratio, it expresses the relationship between how much money a borrower makes monthly and his monthly long-term debt obligations. Lenders use these figures to determine the maximum amount of monthly mortgage payment a buyer can handle.
The two main kinds of DTI numbers are expressed as a pair using the notation
x/y (for example, 28/36).
- The numerator of the DTI (top number), known as the front-end ratio, indicates the percentage of income that goes toward housing costs, which for renters is the rent amount and for homeowners is PITI (PRINCIPAL/INTEREST/TAX/INSURANCE; mortgage Principal and interest, mortgage insurance premium [when applicable], hazard insurance premium, property taxes, and homeowners’ association dues [when applicable]).
- The denominator of the DTI (bottom number), known as the back-end ratio, indicates the percentage of income that goes toward paying all recurring debt payments, including those covered by the first DTI, and other debts such as credit card payments, car loan payments, student loan payments, child support payments, alimony payments, and legal judgments.
If the lender requires a debt-to-income ratio of 28/36, then to qualify a borrower for a mortgage, the lender would go through the following process to determine what expense levels they would accept:
- Using Yearly Figures:
- Gross Income of $45,000
- $45,000 x .28 = $12,600 allowed for housing expense.
- $45,000 x .36 = $16,200 allowed for housing expense plus recurring debt.
- Using Monthly Figures:
- Gross Income of $3,750 ($45,000/12)
- $3,750 x .28 = $1,050 allowed for housing expense.
- $3,750 x .36 = $1,350 allowed for housing expense plus recurring debt.
A commonly used ratio is 33:38 (or 33/38), which means that you spend 33 percent of your income for housing, and no more than five percent more is obligated to consumer debt service. That leaves 62 percent of your income to live on (food, auto, health and life insurance, utilities, clothing and other expenses).
If you make $6000 per month from all sources, for example, you have $1980 (33%) available to spend on housing, and another $300 (5%) available for long-term obligations. As you can see, if your housing costs go down (lower mortgage payment) you can have more available for long-term debt. FHA guidelines are 31:41, and VA guidelines do not have a front-end ratio, but do have a back end of 41. While ratios are simply guidelines, it is important to know where you stand before seeking a mortgage. Since the debt-to-income ratio is entirely in your control, if you are thinking of buying a home in the future, let us help you figure out where you are and put in place some strategies to get you where you need to be to qualify for a loan.
Loan-to-Value Ratio (LTV)
The loan-to-value ratio is a comparison between the mortgage amount and either the appraised value (for refinance) or purchase price (for new purchase) of your home. Lenders factor your loan-to-value ratio into their underwriting considerations. A lower LTV typically allows the borrower to get lower interest rates while a higher LTV is considered riskier for the lender, so the borrower might charge a higher interest. With a high LTV a lender may also require private mortgage insurance (PMI) to protect his investment.
To figure your home’s LTV, divide the mortgage amount by the purchase price or appraised value. A conforming loan typically requires an 80% loan to value, so if your purchase price is $200,000 then an 80% loan would be $160,000 and you would need a down payment of $40,000. If the LTV ratio is very high, where the loan amount is higher than the appraised value, the home is “upside-down” (worth less than the mortgage amount).
Price-to-Income Ratio or Price
While the DTI is based on your personal income, and the LTV is based on a specific home’s value, a price-to-income ratio is based on the affordability of housing for a given geographical area. Typically, it is the ratio of median home pricing to the median household disposable income. This ratio lets you determine if a home is over- or under-priced for an area, or if it is a potentially good investment if you plan to sell your home after a short time. It also gives lenders one more factor in determining risk for the size of loan they might offer.
All three Loan Ratios are common terminology used by lenders. Understanding their meaning and importance can help avoid confusion and disappointment and prepare a home buyer to present a solid request for a home loan. This, in turn, will move the whole process toward loan approval and buying your family’s next home.
Contact us for help to determine if an area is right for your budget, if your debt-to-income ratio is on target, and if the price-to-income ratio for the community you’re looking at has affordable pricing for the families living there. Call us and we’ll help set you on the right path to home ownership.