When analyzing the personal budget of a borrower, lenders use two different debt ratios to determine if the borrower can afford his obligations. These two debt ratios are:
1) Top Debt Ratio
2) Bottom Debt Ratio
The "top" debt ratio is defined as:
Top Debt Ratio = Monthly Housing Expense/Gross Monthly Income
By "monthly housing expense" we mean either the borrower's monthly rent payments, or if she owns her own home, the total of the following:
You will often hear the term P.I.T.I. It refers to (P)rincipal, (I)nterest, (T)axes and (I)nsurance. While P.I.T.I. is not exactly the same as Monthly Housing Expense because it does not include homeowner's association dues, the two terms are often used interchangeably.
Lenders have learned over the years that a borrower's "top" debt ratio should not exceed 25%. In other words, a person's housing expense should not exceed 1/4 of his income. While lenders will often stretch this number to as high as 28%, traditional lending theory maintains that anyone with a debt ratio in excess of 25% stands a good chance of developing budget problems.
The second ratio that lenders use to determine if a borrower can afford her obligations is the "bottom" debt ratio. It is defined as follows:
Bottom Debt Ratio = (Total Housing Expense + Debt Payments)/Gross Monthly Income
The only difference between the two ratios is the inclusion in the numerator of "debt payments." Debt payments include the following: