Most people know that having less debt is a good thing. Most people also want to buy a house. What most people don't take into consideration, however, is that having less debt, while also having more income, is vital for buying a home.
A person's debt to income ratio, often referred to as DTI, is the percentage of a person's monthly total income that goes towards to paying off debt, such as credit card debt, and student loans, along with any fees, taxes, or other expenses related to that debt. In addition, there are two types of DTI called front end ratios and back end ratios.
Front end ratios refer to the percentage of income that goes towards housing. For renters, this would be their monthly rent as well as any kind of housing insurance, such as renter's insurance, that they have. For homeowners, this would be the mortgage principle/interest, any kinds of housing related insurance, property taxes, and so on. Back end ratios, on the other hand, refer to the percentage of a person's income that goes towards any other kinds of debt. Credit card payments, car or student loan payments, and child support are some of the things that are counted here.
Why are the two different kinds of DTI important? It's because the two ratios calculated are expressed as a pair and are used to set standards for banks and other financial institutions. DTI is expressed as the phrase "X/Y", where X is the front end ration and Y is the back end ratio. Many banks want a ratio of 28/36, so having lower debts and higher income is important.
With a lower amount of consumer debt, one has a lower back end ratio. Alternatively, if someone has a large amount of debt but a larger income, their percentage will be lower as well. Having a larger income is also beneficial to one's front end income. The larger the income, the larger 28% of the income will be. This means a larger loan can be taken out, which will often translate to being able to buy a nicer home.
When a decent DTI is achieved and a loan is looked for, it is important to distinguish the different kinds of loans. If a first-time home buyer is looking to take out a loan, an equity loan may not be their best bet, as it usually involves using land or expensive objects (which they may not own yet) as collateral. A home mortgage, which usually involves a line of credit but higher interest rates, may be a better choice.
Regardless, any financial transaction of this kind involves a lot of money and therefore a lot of risk. Because of this, it is very important to research your situation. Speaking with a mortgage expert who can steer you in the right direction is your best bet. Although it may cost you some time and money up front, the savings you can gain by making the right decisions is tremendous.