Understanding Qualifying Ratios: Their Role and Function in Loan Approval

Julia Kagan is a financial and consumer journalist and former senior editor for personal finance at Investopedia.

Definition: Qualifying ratios are financial benchmarks that lenders utilize to evaluate a borrower's capacity to repay loans by comparing their debt commitments against their income.

What Are Qualifying Ratios?

Qualifying ratios serve as essential tools for banks and financial institutions during loan underwriting. Presented as percentages, these ratios help determine whether a loan applicant qualifies for financing and influence the loan's terms.

Lenders rely on qualifying ratios—which compare a borrower's debts to their income—to decide on loan approvals.

Key Takeaways

• The debt-to-income (DTI) ratio, calculated by dividing total expenses by gross income, is crucial in underwriting personal loans, credit cards, and mortgages.
• The housing expense ratio, which compares housing-related costs to gross income, is primarily used in mortgage underwriting.
• While standards vary by lender, a desirable DTI ratio is generally 36% or less, and a housing expense ratio is ideally around 28%.

How Qualifying Ratios Function

Qualifying ratio requirements differ based on lenders and loan types. These ratios are often assessed alongside a borrower’s credit score to evaluate loan applications.

For consumer loans, the debt-to-income and housing expense ratios are the most commonly used qualifying metrics. Standard credit products like personal loans and credit cards focus mainly on the debt-to-income ratio, whereas mortgage loans consider both the housing expense and debt-to-income ratios.

Important

Many online lenders and credit card companies employ automated algorithms in underwriting, enabling loan approvals within minutes.

Qualifying Ratios in Personal Loans

During underwriting for personal loans and credit cards, lenders primarily evaluate two factors: the borrower's debt-to-income ratio and credit score, typically giving both equal consideration.

The debt-to-income ratio (DTI) measures the borrower's recurring debt payments relative to their gross income, calculated either monthly or annually. It reflects how much income goes toward debt obligations. The formula for the monthly DTI is:

Each lender sets its own thresholds, but reputable lenders generally require a DTI of 36% or below. Alternative or subprime lenders might accept DTIs up to approximately 43%.

Qualifying Ratios in Mortgage Loans

Mortgage underwriting evaluates two main ratios alongside the borrower's credit score: the housing expense ratio and the debt-to-income ratio.

Important

In mortgage lending, the housing expense ratio is often called the front-end ratio, while the debt-to-income ratio is known as the back-end ratio.

Housing Expense Ratio

This ratio compares a borrower’s total housing-related expenses to their gross income. Lenders typically consider mortgage principal and interest payments, but may also include homeowners insurance, hazard insurance, property taxes, utilities, homeowners association fees, and mortgage insurance. These combined housing costs are divided by the borrower’s income to calculate the housing expense ratio, using either monthly or annual figures.

Underwriters use the housing expense ratio not only to approve mortgages but also to determine the loan amount an applicant can afford. Most lenders prefer a housing expense ratio of about 28% or less. Higher ratios may be accepted if there are compensating factors such as a low loan-to-value ratio or excellent credit history. Regional housing market conditions can also influence acceptable ratios; in high-cost areas like New York City or San Francisco, housing expenses may reach up to one-third of income.

Debt-to-Income Ratio

The debt-to-income ratio used in mortgage underwriting is the same as that for personal loans. Generally, lenders seek a DTI ratio around 36% for mortgage approvals. However, some government-backed loan programs allow higher DTIs: Fannie Mae permits DTIs up to approximately 45%, and Federal Housing Administration (FHA) loans accept ratios near 50%.

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