Tag Archives: metric

What is the Debt to Income Ratio?

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OppLoans.com quoted me in What is the Debt to Income Ratio? It opens,

One of the great things about credit is that it lets you make purchases you wouldn’t otherwise be able to afford at one time. But this arrangement only works if you are able to make your monthly payments. That’s why lenders look at something called your debt to income ratio. It’s a number that indicates what kind of debt load you’ll be able to afford. And if you’re looking to borrow, it’s a number you’ll want to know.

Unless your rich eccentric uncle suddenly dies and leave you a giant pile of money, making any large purchase, like a car or a home, is going to mean taking out a loan. Legitimate loans spread the repayment process over time (or a longer term), which makes owning these incredibly expensive items possible for regular folks.

But not all loans are affordable. If the loan’s monthly payments take up too much of your budget, then you’re likely to default. And as much as you, the borrower, do not want that to happen, it’s also something that lenders want to avoid at all costs.

It doesn’t matter how much you want that cute, three-bedroom Victorian or that sweet, two-door muscle car (or even if you’re just looking for a personal loan to consolidate your higher interest credit card debt). If you can’t afford your monthly payments, reputable lenders aren’t going to want to do business with you. (Predatory payday lenders are a different story, they actually want you to be unable to afford your loan. You can read more about that shadiness in our personal loans guide.)

So how do mortgage, car, and personal lenders determine what a person can afford before they lend them? Well, they usually do it by looking at their debt to income ratio.

What is the debt to income ratio?

Basically, it’s the amount of your monthly budget that goes towards paying debts—including rent or mortgage payments.

“Your debt to income ratio is benchmark metric used to measure an individual’s ability to repay debt and manage their monthly payments,” says Brian Woltman, branch manager at Embrace Home Loans (@EmbraceHomeLoan).

“Your ‘DTI’ as it’s commonly referred to is exactly what it sounds like. It’s calculated by dividing your total current recurring monthly debt by your gross monthly income—the amount you make before any taxes are taken out,” says Woltman. “It’s important because it helps a lender to determine the proper amount of money that someone can borrow, and reasonably expect to be paid back, based on the terms agreed upon.”

According to Gerri Detweiler (@gerridetweiler), head of market education for Nav (@navSMB), “Your debt to income ratio provides important information about whether you can afford the payment on your new loan.”

“On some consumer loans, like mortgages or auto loans, your debt to income ratio can make or break your loan application,” says Detweiler. “This ratio typically compares your monthly recurring debt payments, such as credit card minimum payments, student loan payments, mortgage or auto loans to your monthly gross (before tax) income.”

Here’s an example…

Larry has a monthly income of $5,000 and a list of the following monthly debt obligations:

Rent: $1,200

Credit Card: $150

Student Loan: $400

Installment Loan: $250

Total: $2,000

To calculate Larry’s DTI we need to divide his total monthly debt payments by his monthly income:

$2,000 / $5,000 = .40

Larry’s debt to income ratio is 40 percent.

David Reiss (@REFinBlog), is a professor of real estate finance at Brooklyn Law School. He says that the debt to income ratio is an important metric for lenders because “It is one of the three “C’s” of loan underwriting:

Character: Does a person have a history of repaying debts?

Capacity: Does a person have the income to repay debts?

Capital: Does the person have assets that can be used to retire debt if income should prove insufficient?

What is a good debt to income ratio?

“If you listen to Ben Franklin, who subscribed to the saying ‘neither a borrower nor lender be,’ the ideal ratio is 0,” says Reiss. But he adds that only lending to people with no debt whatsoever would put home ownership out of reach for, well, almost everyone. Besides, a person can have some debt on-hand and still be a responsible borrower.

“More realistically, in today’s world,” says Reiss, “we might take guidance from the Consumer Financial Protection Bureau (CFPB) which advises against having a DTI ratio of greater than 43 percent. If it creeps higher than that, you might have trouble paying for other important things like rent, food and clothing.”

“Requirements vary but usually if you can stay below a 33 percent debt-to-income ratio, you’re fine,” says Detweiler. “Some lenders will lend up to a 50 percent debt ratio, but the interest rate may be higher since that represents a higher risk.”

For Larry, the guy in our previous example, a 33 percent DTI would mean keeping his monthly debt obligations to $1650.

Let’s go back to that 43 percent number that Reiss mentioned because it isn’t just an arbitrary number. 43 percent DTI is the highest ratio that borrower can have and still receive a “Qualified Mortgage.”

Consumer-Friendly Financial Innovation

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lightbulbsThe Consumer Financial Protection Bureau issued a Final Policy Statement on No-Action Letters. According to the press release, the policy is intended to facilitate consumer access to financial products and services that promise substantial benefit to consumers.” More specifically, according to the Final Policy Statement itself,

Under the Policy, Bureau staff would, in its discretion, issue no-action letters (NALs) to specific applicants in instances involving innovative financial products or services that promise substantial consumer benefit where there is substantial uncertainty whether or how specific provisions of statutes implemented or regulations issued by the Bureau would be applied (for example if, because of intervening technological developments, the application of statutes and regulations to a new product is novel and complicated). The Policy is also designed to enhance compliance with applicable federal consumer financial laws. A NAL would advise the recipient that, subject to its stated limitations, the staff has no present intention to recommend initiation of an enforcement or supervisory action against the requester with respect to a specified matter. NALs would be subject to modification or revocation at any time at the discretion of the staff, and may be conditioned on particular undertakings by the applicant with respect to product or service usage and data-sharing with the Bureau. Issued NALs generally would be publicly disclosed. NALs would be nonbinding on the Bureau, and would not bind courts or other actors who might challenge a NAL recipient’s product or service, such as other regulators or parties in litigation. The Bureau believes that there may be significant opportunities to facilitate innovation and access, and otherwise substantially enhance consumer benefits, through the Policy. (1-2)

Colleagues and I had commented on this policy when it was first proposed, arguing that it should incorporate metrics to ensure that it is achieving its stated goals. It does not seem that the CFPB agreed with our comments. So, while I think the final policy is a step in the right direction, I am not sure if we can really measure how good of a step it is.

Mortgage Servicer Accountability

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Joseph A. Smith, Jr, the Monitor of the National Mortgage Settlement, issued his third set of compliance reports (I blogged about the second here). For those needing a recap,

As required by the National Mortgage Settlement (Settlement or NMS), I have filed compliance reports with the United States District Court for the District of Columbia (the Court) for each servicer that is a party to the Settlement. The servicers include four of the original parties – Bank of America, Chase, Citi and Wells Fargo. Essentially all of the servicing assets of the fifth original servicer party, ResCap, were sold to and divided between Ocwen and Green Tree pursuant to a February 5, 2013, bankruptcy court order. Accordingly, Ocwen and Green Tree are now subject to the NMS for the portions of their portfolios they acquired from ResCap.1 These reports provide the results of my testing regarding compliance with the NMS servicing standards during the third and fourth calendar quarters of 2013, or test periods five and six. They are the third set of reports for the original four bank servicers, the second report for Ocwen and the first report assessing Green Tree. (3)

The Monitor concludes that Bank of America, Citi, Chase, Ocwen and Wells Fargo “did not fail any metrics during the most recent testing periods.” (2) The Monitor also reports on “fourth-quarter compliance testing results for the loans Green Tree acquired from the ResCap Parties. Green Tree implemented the Settlement’s servicing standards after such acquisition. Green Tree failed a total of eight metrics during this time period.” (2) The metrics that Green Tree failed include a number of practices that have made the lives of borrowers miserable during the foreclosure crisis. They are,

  • whether the servicer accurately stated amounts due from borrowers in proofs of claims filed in bankruptcy proceedings
  • whether the servicer accurately stated amounts due from borrowers in affidavits filed in support for relief from stay in bankruptcy proceedings
  • whether loans were delinquent at the time foreclosure was initiated and whether the servicer provided borrower with accurate information in a pre-foreclosure letter
  • whether the servicer provided borrower with required notifications no later than 14 days prior to referral to foreclosure and whether required notification statements were accurate
  • whether the servicer waived post-petition fees, charges or expenses when required by the Settlement
  • whether the servicer has documented policies and procedures in place to oversee third party vendors
  • whether the servicer responded to government submitted complaints and inquiries from borrowers within 10 business days and provided an update within 30 days
  • whether the servicer notified the borrower of any missing documents in a loan modification application within five days of receipt (9, emphasis added)

These metrics seem pretty reasonable — one might even say they are a low bar for sophisticated financial institutions to exceed. Until the servicing industry can do such things as a matter of course, close government regulation seems appropriate. The monitor notes that “work still remains to ensure that the servicers treat their customers fairly.” (2) Amen to that, Monitor.