Here are the Financial Ratios that Lenders focus on the most:
The process of securing a loan, as a mortgage or otherwise, can initially appear overwhelming and potentially repetitive, but CalcuTrack is here to help. It is important to remember that the loan application and approval process is designed to protect both the lender and the borrower. It is highly regulated and has been extensively developed to determine if the borrower is capable of repaying the loan in question. To make this determination, lenders will use a series of financial ratios, to quantitatively create a credit analysis or credit score to determine the ability for loan repayment. Having a complete understanding of which financial ratios are being used to determine if you qualify for the loan in question can take the guess work out of the application process and also offer in-depth understanding of your current financial situation. This is why financial ratios are such a key process to understand in the lending process.
What type of Financial Ratios do lenders most often review for loan approval?
Banks and other loan issuing intuitions will often have their own unique list of financial ratios which they review to determine whether or not to approve a loan. This being said, there are very specific financial ratios however which are universal and are important to understand. These include the following:
- Total Debt to Income Ratio
- Income to Mortgage Debt Ratio
- Consumer Debt to Income Ratio
- Credit Utilization Ratio
The specific name used to describe these ratios may also vary slightly, but at their core the information they require to calculate and the resulting figures are the same.
Total Debt to Income Ratio
The Debt to Income Ratio , abbreviated as DTI ratio, is one of the most straightforward and basic ratios taken into consideration during the loan application process. The DTI ratio determines two factors; the first is if the borrower is capable of making the monthly payments and if there is the ability to pay off the loan and satisfy the terms. The DTI ratio is calculated by determining what percentage of your gross monthly income is already allocated for paying your monthly debts.
How To Calculate Your DTI Ratio
To calculate your DTI ratio, first gather all of your monthly bills, specifically those which would appear on your credit report. These include, but are not limited to fix monthly bills such as rent and auto loan repayment and bills which are variable such as a monthly credit card bill. For the varying bills use your minimum monthly payment. If you already have a monthly mortgage payment you will have to determine your principal, interest, taxes, and insurance, abbreviated PITI. For more information on your PITI and how it is calculated and used, please click HERE. For any debts which may require payments less frequently than monthly, be sure to determine what amount would be paid toward them if there were. For example, if it is a yearly payment, you would divide that yearly amount by twelve to determine its monthly value. Once each of these individual monthly debts are determined, add them together to figure out your total monthly debts.
Next, a total monthly gross income must be determined. It is important to note that proof of this total gross income will likely be required in the form of W2 or other such documentation. Again, this is a value of gross income over the course of one month.
Lastly, divide your combined total monthly debts by your monthly gross income and multiply it by one hundred. The value obtained is your DTI Ratio. This number can be looked at as the percentage of income which is already reserved for expenses. For more information on evaluating this ratio and what your numbers mean to a bank during the loan process click HERE.
Income to Mortgage Debt Ratio
How much can and should an individual spend on their mortgage? As the most common loan type, the Mortgage to Debt Ratio and its impact on both a borrower and lender has been researched to a very specific science. In fact, lender evaluation can be broken down into two categories, Frontend and Backend ratios.
The Frontend ratio comprises all expenses associated with housing expenses; these include mortgage, insurance, property taxes, and home association fees if applicable. Simply, it includes those expenses which are attached directly to owning a home. The Backend Ratio is a combination of all items included in the frontend ration and all other regular monthly expenses.
To calculate the Frontend Ratio, which is also called the Mortgage to Debt Ratio, the proposed mortgage, insurance, property taxes, and home association fees are added together, then divided by the individual’s gross income, and multiplied by one hundred. This will demonstrate how much of the gross income is or will be used for housing. The universally accepted idea by reputable lenders is that the Frontend Ratio or Mortgage to Debt Ratio should not exceed 28%. The Backend ratio should not exceed 36%. For more specific information on what the Mortgage Debt Ratio and Frontend and Backend Ratios mean to the lending process click HERE.
Consumer Debt to Income Ratio
The Consumer Debt to Income Ratio, which is commonly abbreviated DTI (Debt to Income), is calculated for a monthly determination of what percentage of your gross income is owed to pay debts. The debts considered for the DTI are items such as current mortgages, credit card bills, and loans. The value of knowing the DTI is to understand if an individual is over extended each month. Can this person make their current monthly bills and potentially be able to take on more debt?This is measured against an individual’s gross monthly income. To calculate the DTI those monthly debts which fall into this category are added together, divided by gross monthly income, and the total is multiplied by 100 to gain a percentage. This value is then used to determine if a borrower can potentially make their monthly payments on a new loan. The DTI is also considered in conjunction with the Credit Utilization Ratio, which takes into account how much credit you have available and how much you are using. In other words, to understand if the individual maxed out their credit cards or paid them off every month. These ratios give a fuller picture of a borrower’s financial health. Ideally, a lender prefers or requires a DTI of less than 36%. What is extremely important to note when it comes to DTI is that a value over 43% is very unlikely to be approved for a Qualified Loan. Some exceptions are made but it can become very difficult. A Qualified Loan or Qualified Mortgage is a very stable loan which offers terms which give the borrower the best ability to complete the terms of the loan.
Credit Utilization Ratio
The Credit Utilization Ratio is sometimes referred to as debt to credit ratio, but this term is slightly misleading. While utilized credit is technically a debt, when calculating a Credit Utilization Ratio it isn’t necessarily thought of as what is owed, but a percentage of what has been used vs what is available. To calculate this ratio the amount of credit used is divided by the amount of credit available. For example, if a credit card has a credit limit of $1,000 dollars and there now only remains $500 available, the credit utilization ratio for this particular line of credit would be 50%. To determine an individual’s total Credit Utilization Ratio this same calculation is used encompassing all lines of credit and what is remaining with each.
The Credit Utilization Ratio can fluctuate, and this is why it is sometimes referred to as ‘revolving’ credit, each time a purchase is made on a credit card the Credit Utilization Ratio increases, conversely, when a payment is made on said credit card the Credit Utilization Ratio decrease. This is vital to remember before applying for a loan, having credit is great, but it inspires confidence in lenders to see that only a small percentage has been used. It is commonly understood that a good, viable Credit Utilization Ratio is below 30%. When the ratio is higher than his amount it signals to lenders that the individual has difficulty handling their finances.
On closing, it’s important to mention that while understanding financial ratios can appear overwhelming at first, when broken down individually they reveal themselves as very straightforward tools to protect both the borrower and the lender. They can also offer peace of mind when determining if the elements of a loan will work for you. Ratios are useful and taking the time to understand yours can make the loan processes smoother and most beneficial.