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Basics and Types of Debt-to-Income Ratio

It is important to determine how much you can afford to borrow. A commonly used tool for this by lenders is debt-to-income ratio. In order to make loans affordable to the particular client lenders calculate payments as a percentage of the total income of the client. Debt-to-income ratios allow lenders to keep monthly loan payments within reasonable levels. They are also used as the basis to determine the total amount of money it is reasonable to lend to the client.

Housing Expense Ratio

This ratio is a type of a debt-to-income ratio. It is also referred to as "front" debt to income ratio. The housing expense ratio is used to determine the percentage of your income that is allocated for the coverage of the housing payments you make every month. The components of housing payments are the same as the ones of monthly payments, namely:

  • Principal
  • Interest
  • Taxes
  • Insurance

There are certain limits that are set to the debt-to-income ratio. These limits are set by lenders and are considered as the desired levels that should be maintained. Thus, they may state a particular percentage of your gross monthly income to go for housing expense and this percentage should not be exceeded.

Long-Term Debt Ratio

This is again a type of debt-to-income ratio. The long-term debt ratio is commonly referred to as "back" debt to income ratio. It is used as a gauge of the portion of your monthly income that is allocated for the coverage of all debt payments. This ratio includes such debts as housing expenses, credit cards, car loans and etc.

Lenders tend to put a limit on the desired level of the long-term debt ratio too.

As you have noticed from the explanation of the housing expense ratio and the long-term debt ratio, both of them have alternative names starting with "back" and "front". The reason for this naming is that lenders display debt-to-income ratio by using two numbers, for example 31/35. The first number stays for the housing expense ratio, whereas the second number is used to indicate the long-term debt ratio.

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