When analyzing the personal budget of a borrower, lenders use two different debt ratios to determine if the borrower can afford his obligations. These two debt ratios are:
- Top Debt Ratio
- Bottom Debt Ratio
The "top" debt ratio is defined as:
Top Debt Ratio = Monthly Housing Expense/Gross Monthly Income
By "monthly housing expense" we mean either the borrower's monthly rent payments, or if he/she owns a home, the total of the following:
- 1st mortgage payment on home
- Real estate taxes (annual cost/12)
- Fire insurance (annual cost/12)
- Homeowner's association dues (if the home is a condo or townhouse)
- Second mortgage payment (if any)
- Third mortgage payment (if any)
You will often hear the term PITI. It refers to (P)rincipal, (I)nterest, (T)axes and (I)nsurance. While PITI is not exactly the same as Monthly Housing Expense because it does not include homeowner's association dues, the two terms are often used interchangeably.
Lenders have learned over the years that a borrower's "top" debt ratio should not exceed 25%. In other words, a person's housing expense should not exceed 1/4 of his income. While lenders will often stretch this number to as high as 28%, traditional lending theory maintains that anyone with a debt ratio in excess of 25% stands a good chance of developing budget problems.
The second ratio that lenders use to determine if a borrower can afford his/her obligations is the "bottom" debt ratio. It is defined as follows: Bottom Debt Ratio = (Total Housing Expense + Debt Payments) / Gross Monthly Income
The only difference between the two ratios is the inclusion in the numerator of "debt payments." Debt payments include the following:
- Car payments
- Charge card payments
- Payments on installment loans, for example - a payment on a washer & dryer that the borrower purchased
- Payments on personal loans, for example, a signature loan from the borrower's bank.
What is not included in "debt payments" is Utilities such as PG&E, water or telephone and payments on real estate loans. Real estate loans are usually offset first by the net rental income from the property. If the borrower has a net positive cash flow from all his rentals, then the net income is usually added to his "gross monthly income." If the borrower has a net negative cash flow from all of his rental properties, then the amount of the negative cash flow is usually added to the numerator of the "bottom" debt ratio as if it were a monthly debt obligation, like a car payment.
Traditional lending theory maintains that a borrower's "bottom" debt ratio should not exceed 33 1/3%. In other words, the total of the borrower's housing expense and debt obligations should not exceed 1/3 of his income. Lenders often will stretch on this ratio to as high as 36%, and some have even been known to stretch as high as 40% or more. Obviously a loan with a debt ratio of 40% is a far more risky loan than a loan with a debt ratio of 32%.