Mortgage debt-to-income ratios determine how much potential homebuyers can borrow
Anyone considering buying a house needs to understand debt-to-income ratios because these measures of a borrower’s capacity to repay the debt is fundamental to mortgage underwriting.
Debt-to-income ratios are concerned with monthly income. These are not measures of total debt or total income, only the monthly payments on debt compared to monthly gross income. Notice also that the benchmark is monthly gross income, not take-home pay.
The monthly gross income standard is important because tax policy can pose problems for borrowers with high debt-to-income ratios because after paying their mortgage and their taxes, they don’t have much left over to live a life.
Strangely, lower income borrowers can often endure higher debt-to-income ratios because they receive other tax benefits that compensate. The middle- and upper-income tax brackets pay higher tax rates, but they also gain the advantage of the home mortgage interest deduction, which allows them to afford higher debt-to-income ratios. The highest tax brackets often struggle the most with high debt-to-income loans because their tax deductions may be limited by the AMT or caps on the allowable mortgage amounts. But then again, they also make the most money and enjoy the most disposable income, so arguably, they can afford the increased debt by cutting back on other expenditures.
Front-end and back-end DTIs
Lenders measure two debt-to-income ratios when the evaluate a borrower’s capacity to repay: the front-end ratio, and the back-end ratio.
The front-end ratio is the monthly burden for housing divided by the borrower’s monthly gross income. The monthly housing burden is often described as PITI, which is short for principal, interest, taxes, and homeowners insurance. But PITI also includes property-specific costs like homeowners association dues, Mello Roos taxes, or private mortgage insurance.
People shopping for homes in beach communities or other highly desirable areas probably noticed that condos often seem reasonably priced, even cheap by neighborhood standards. However, upon closer examination, these condos are often saddled with huge HOA dues payments that serve to increase PITI. So while the condo may look affordable, due to the impact the HOA dues have on PITI — and thereby the front-end ratio — the condo often isn’t affordable after all.
At one point, a 28% front-end debt-to-income ratio was considered the limit, but since the housing bust, the GSEs set a new standard of 31% for an allowable front-end DTI, so that number is now fairly standard in mortgage underwriting today. Years of experience has shown that borrowers with debt-to-income ratios in excess of 31% default at high rates, which isn’t terribly surprising considering the impact higher debt-service payments has on other lifestyle expenses.
The FHA and VA allow much higher front-end ratios, and many government watchdogs are critical of this practice because high front-end ratios signify overextended borrowers more likely to default. Despite the criticism, these high-risk and high-burden loans are often the only path to homeownership in supply-restricted markets in Coastal California, so they are common despite their drawbacks.
The back-end ratio is the total monthly debt service divided by the borrower’s income. It includes all the costs of the front-end debt-to-income ratio plus any other debt-service payments the borrower must make. Items the most often impact the back-end ratio are student loans, auto loans, and credit card payments. Any and all consumer debt payments show up here.
The new qualified mortgage rules cap back-end debt ratios at 43% of gross income for conforming loans (Again FHA and VA are exempt). This cap was in response to the enormous debt burdens exposed when lenders abdicated all lending prudence and gave Ponzis unlimited debt during the housing mania. In 2007, the back-end ratios of the average borrower, not the extreme, the average borrower, was over 75%.
Remember, this is of gross income, so unless these people don’t pay taxes or don’t eat, they were obviously Ponzis relying on fresh infusions of debt to sustain their lives. The 43% debt-to-income cap is a good idea. Nobody should be paying more than that to lenders, and realistically, nobody can unless they go Ponzi.
The back-end debt ratio is a major problem in the housing market today. With the explosive growth of student loan debt over the last 15 years, many potential homebuyers get hammered by their back-end debt ratio. Many people could easily afford the front-end ratio to afford the home, but due to the high student loan payments they make, their back-end ratio is too high.
To bring the back-end ratio down to 43%, the front-end ratio must get smaller, so if student loan payments make up 20% of their gross income — which many do — then they only have 23% of their income left over for a front-end ratio. Then the front-end ratio isn’t large enough to buy what they want. Many potential homebuyers are sidelined by this problem.
In our era of inexpensive debt, people accumulated a great deal of it, so it isn’t only student loans that create the problem. One very common mistake new college graduates make is to go buy or lease an expensive new car. Even if they don’t have a student loan, if they spend more than 12% of their gross income on a car payment, that debt alone starts eating into their front-end ratio.
Further, since credit card debt is nearly ubiquitous, nearly everyone has a monthly credit card payment to add to their woes.
I would go as far as to say that the 43% debt-to-income cap does more to restrict home lending than any other regulations in Dodd-Frank, but does that mean we should rescind this provision? No, not at all.
This cap was put in place for two good reasons: (1) borrowers can only sustain debt-to-income ratios higher than 43% temporarily while they go Ponzi, so larger debts are not sustainable, and (2) these loans only serve to inflate house prices, and since the ratios are unsustainable, housing will crash, Ponzi borrowers will default, and we will repeat the mistakes of the housing mania. This cap is a stabilizing feature of Dodd-Frank, not a bug.
It’s also worth noting that the qualified mortgage rules in Dodd-Frank don’t provide an absolute prohibition of excessive debt-to-income ratios or other forms of toxic financing. Instead, the law relies on MBS pool put-backs, a 5% risk retention requirements, and the threats of consumer lawsuits to make these loan programs so costly that no lenders bother with them.
Currently, no lenders will underwrite these loans, and no investors are willing to buy them, but that might change in the future. Hopefully, we learned some of the lessons of the housing bubble, but people are wise to be vigilant about lender foolishness. If we allow lenders to circumvent these rules and inflate another housing bubble, the losses will fall upon the US taxpayer. With the moral hazard residual from the bailouts of the last bubble, if we inflate another one, it will be truly epic.