Debt-to-Income Ratio

Overview

When considering a loan request, lenders use different ratios to determine creditworthiness for a borrower. Even though commercial real estate financing relies heavily on the property’s net operating income to underwrite the loan, borrowers are viewed as a secondary source of repayment for the loan in case anything should interrupt the cash flow from the property. Besides examining a borrower’s credit history, net worth, and liquid assets, a lender will also consider the borrower’s debt-to-income ratio.

Definitions

The debt-to-income ratio (DTI) is the ratio between a borrower’s monthly obligations, such as credit card debt, automobile loans, and real estate loans, and the monthly gross income, including salary, commissions, interest income, and social security benefits. Some lenders also refer to this as the Personal Debt Ratio. In most cases, lenders prefer a ratio of less than 50%, although this of course can depend on the lender and loan program

The debt-to-income ratio can be calculated according to the following:

Monthly Obligations / Gross Income = Debt-to-Income

As explained above, monthly obligations are the payments that a borrower must make every month for both short-term and long-term liabilities. The gross income can encompass every source of income available to a borrower, including net rental income from other investment properties.

While not an important investment concept for agents, the debt-to-income ratio nonetheless can pose a challenge for borrowers seeking financing. When calculating the DTI ratio, most lenders will refer to the two years of tax returns for a borrower in order to determine the average adjusted gross income (AGI) for a borrower. The AGI will take into account personal income, passive income, and net rental income. In addition, lenders will add back depreciation allowances (from Schedule E) and net operating losses (from Schedule C) to arrive at a more accurate understanding of a borrower’s capacity for repayment.

Yes, this is perhaps too much information for you to know right now, but it is an essential part of determining creditworthiness for borrowers seeking financing!

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