Qualification Ratio

A qualification ratio notes the proportion of either debt to income or housing expense to income. Mortgage lenders use qualification ratios to determine a borrower's creditworthiness for certain loan amounts. Generally, a borrower's housing expenses alone, which includes any homeowner's insurance, taxes and condominium fees, cannot exceed 28 percent of a borrower's monthly gross income. The borrower’s debt-to-income ratio (DTI), which includes housing expenses plus debt, generally cannot exceed 36 percent of monthly gross income.

A qualification ratio takes the total annual income of your household and divide it by 12. So you and your spouse earn a combined $96,000 a year. Your family's gross income is $8,000 a month. Multiply $8,000 by .28 and you’ll get your housing expense ratio, which lenders call the front, or front-end ratio. In this case your family would be eligible for total monthly housing expenses of $2,240. Note this includes property taxes, homeowner’s insurance, private mortgage insurance (PMI) and charges such as condo fees. 

Now take the $8,000 monthly income and multiply it by .36. This is your debt-to-income ratio, often called the back, or back-end ratio, and you'll get $2,880. Now deduct your monthly debt payments from the $2,280 number, which consist of a $300 monthly car payment and a $400 monthly student loan payment. This leaves you with $2,180 for housing expenses. Note that this figure is lower than the front-end ratio.

Banks will always use the lower of the two numbers to determine how large a loan to offer you.

Credit card debt also counts toward your back-end ratio, but it’s complicated. Lenders used to apply the minimum payment on a credit card balance and call that monthly debt. But that system wasn't fair to credit card users who paid off their balance in full every month and used credit cards mainly for convenience and reward points. Now, most lenders look at the borrower’s total revolving balance and apply 5 percent of the total as monthly debt. Say you carry $10,000 in credit card debt. In this case, the bank tacks on $500 in monthly debt to your back-end ratio. 

Qualification ratios are not rigid. Excellent credit history often mitigates a a poor ratio, for example. In addition, some borrowers who do not meet the standard qualifying ratios take advantage of special mortgage programs offered by some banks. The added risk of default by these borrowers means that they generally pay higher interest rates versus mortgages that meet standard qualifying ratios.