Question on Debt to Income ratio

[Bob B.]

I've been doing a little on-line research on getting approved for a home mortgage. I've learned quite a bit about "front end" and "back end" debt to income ratios.

What I've learned is that conventional financing limits are typically 28/36. Or that no more than 28% (the front end) of your monthly payment obligations be related to housing, and no more than 36% (the back end) of your monthly payment obligations be related to other debt.

I've also learned that the calculations seem to be based on gross income rather than net. That makes no sense to me. I have a number of deductions that come straight out of my monthly pay check - including my portion of employer matched retirement contributions, my portion of employer sponsored health insurance, and my contribution to life insurance. And of course, taxes.

My net monthly income, and thus my capacity to repay a loan, can vary compared to someone with the exact same gross monthly income.

So, my question is - is it typical for lenders to calculate debt to income ratios on gross monthly income? And if so - isn't that crazy?

[skydivingchic]

Yes, the lenders use your gross pay to calculate the ratios as far as I know. What would stop someone from stopping all these withdrawls (except taxes of course, though even that could be manipulated by upping the number of exemptions) for long enough to get approved for a mortgage and then re-upping the deducts? So figuring ratios on the net pay doesn't really give a better picture from a lender standpoint. However, it would certainly be a good idea for individuals to consider this when obtaining a loan.

[riverwed070707]

But these are things you choose to participate in. Why should someone who contributes more to retirement be considered less able to repay a loan than someone who makes the same and contributes nothing? I think your reasoning is flawed.

Obviously the banks need to leverage risk, but we can't count on them to restrict people based on things like their employer healthcare plan, retirement contributions, etc. What about HSAs? Those are pretax -- should saving for my health expenses in advance make me qualify for a smaller loan than someone who has to scrounge up the money after the bills come?

[Bob B.]

But these are things you choose to participate in.

Exactly - these are thing I choose. Just as having chosen to take on excessive debt that would affect the calculation.

If I choose a Cadillac heath plan, or a huge life insurance policy, it should affect my ability to get a loan.

It certainly does affect my capacity to pay the loan.

[Bob B.]

Yes, the lenders use your gross pay to calculate the ratios as far as I know. What would stop someone from stopping all these withdrawls (except taxes of course, though even that could be manipulated by upping the number of exemptions) for long enough to get approved for a mortgage and then re-upping the deducts? So figuring ratios on the net pay doesn't really give a better picture from a lender standpoint. However, it would certainly be a good idea for individuals to consider this when obtaining a loan.

That makes a lot of sense. Thanks.

[bjl584]

Yes, gross income is used because it's easier to calculate than by making a custom calculation for each individual. A person may or may not contribute to a 401K, or company healtcare programs, or whatever. It's better to do your own calculation to determine if you can afford a mortgage or not. The banks will typically "upsell" you anyway, even post housing crisis, and make you believe that you can afford more house than you really can.

[riverwed070707]

Exactly - these are thing I choose. Just as having chosen to take on excessive debt that would affect the calculation.

If I choose a Cadillac heath plan, or a huge life insurance policy, it should affect my ability to get a loan.

It certainly does affect my capacity to pay the loan.

Sure but unlike debt you've already aquired, you can stop contributing to those things at any time. They aren't debts, why should they be held against you? That's like saying the bank needs to consider whether the applicant has cable tv or a data plan on their cell phone. Its beyond the scope of their duty -- its the consumers responsibility to take those things into consideration and determine what they can afford.

[MonkeyMama]

It seems to me that anyone's decisions are kind of moot (paycheck deductions) because they can always change them. The thing is it is impossible to make apples to apples comparison when it comes to net income. If someone chooses to max out their 401k, would they really keep that decision rather than pay their mortgage (if their spouse was laid off or something)? & does someone who max out their 401k have less ability to pay off a mortgage, versus someone who is offered no benefits at work and only has taxes deducted from their check? Um, no?

I agree with what skydivingchick said though. Of course you want to consider your net situation (& all of your bills) when getting a loan. I was just commenting on this because we are in the middle of a refinance and I don't have decent employer insurance for anything. We pay about $12,000 per year for our health plan, privately. I Was just commenting how the lender seems so concerned with our debt (we have none) and yet hell would freeze over before I fell behind on my health insurance - it is probably more important than our mortgage, in the grand scheme of things. But, you know, banks don't look at that stuff. They seem overly concerned with *income* and *debt* but didn't ask if we have any life or disability insurance. So, you know, they follow some time tested formula that focuses on the narrow, and ignore all the rest which may be more important. But I guess it's the law of average. I have just never understood some of the logic on home loans.

[fe2o3ez]

They seem overly concerned with *income* and *debt* but didn't ask if we have any life or disability insurance. So, you know, they follow some time tested formula that focuses on the narrow, and ignore all the rest which may be more important. But I guess it's the law of average.

This is what you have to remember - and it goes back to the OP statements on 28/36% - the lenders are conservative by nature. They aren't going to concern themselves with anything but the front and back end ratios of your income. Frankly, they don't care what you are doing with your other 64-72% of income, as long as you don't have other creditors standing in line ahead of them. They know that taxes will automatically take a chunk, food will take a chunk, insurance and retirement may take some, etc. They won't allow you to take out any ratio of debt that would put them at risk of not being paid. Right now, that conventional wisdom sits at 28/36%.

[disneysteve]

Frankly, they don't care what you are doing with your other 64-72% of income, as long as you don't have other creditors standing in line ahead of them.

Exactly. Each of us spends that 72% in a different way so there is no way a potential lender could evaluate people based on that. They need to look at the gross to keep everything equal among applicants.

[LivingAlmostLarge]

i agree because we live on I think 40% of my DH's gross coming in and our mortgage is about 50% of that. According to people if we did it based on "net" we'd be in the hole but somehow we manage just fine, save for retirement, short term and long term. It's just that a lot of money goes out before it ever hits our bank account.