Qualification Ratio

Qualification Ratio

The term qualification ratio refers to the measure of a borrower's creditworthiness that helps lenders decide whether to extend them credit. The first ratio involves the applicant's total monthly debt to total monthly income while the other calculates the total monthly debt payments versus the total monthly income. The first is the monthly debt-to-income ratio (DTI) while the second one is called the back-end ratio, which calculates the monthly debt payment to income. A qualification ratio calculates a borrower's ability to repay a loan, typically as a proportion of either debt to income or housing expenses to income. Another qualification ratio, the borrower’s DTI, includes housing expenses plus debt, and generally cannot exceed 36% of monthly gross income.

A qualification ratio calculates a borrower's ability to repay a loan, typically as a proportion of either debt to income or housing expenses to income.

What Is a Qualification Ratio?

The term qualification ratio refers to the measure of a borrower's creditworthiness that helps lenders decide whether to extend them credit. Used in the underwriting process, a qualification ratio calculates how likely it would be for a borrower to repay a loan.

Lenders normally use one of two qualification ratios in their underwriting process. The first is the monthly debt-to-income ratio (DTI) while the second one is called the back-end ratio, which calculates the monthly debt payment to income. Qualification ratios also determine the terms of any credit application including repayment terms and interest rate.

A qualification ratio calculates a borrower's ability to repay a loan, typically as a proportion of either debt to income or housing expenses to income.
Lenders use qualification ratios to help underwrite a loan application for approval and/or the terms of credit that should be extended.
Lenders use the front-end ratio in conjunction with the back-end ratio to determine how much to lend.
Certain qualitative factors may also come into play, giving lenders some wiggle room to extend or deny a loan.

Understanding Qualification Ratios

Consumer credit applications provide lenders with a window into the personal and financial situation of applicants. Consumers are required to provide information such as their name, address, and financial information on these applications. This information includes employment information, income, and debts. Lenders use this information in the underwriting process to determine whether or not to approve a consumer's credit application for most credit products, especially loans and mortgages.

A borrower's housing expenses alone, which include homeowners insurance, taxes, utilities, and neighborhood or association fees, cannot exceed 28% of a borrower's monthly gross income. Another qualification ratio, the borrower’s DTI, includes housing expenses plus debt, and generally cannot exceed 36% of monthly gross income.

Higher ratios indicate an increased risk of default. But some lenders may accept higher ratios in exchange for certain factors, such as substantial down payments, sizable savings, and favorable credit scores. For example, a lender may offer a mortgage to a borrower with a high front-end ratio if they pay half of the purchase price as a down payment.

Lenders generally prefer a front-end ratio of no more than 31% or less for Federal Housing Administration (FHA) loans.

As mentioned above, lenders generally use one of two qualification ratios to determine the likelihood of repayment. This is based on the information provided by the applicant as well as their credit report. The first ratio involves the applicant's total monthly debt to total monthly income while the other calculates the total monthly debt payments versus the total monthly income. These ratios take the total annual income of a household and divide it by 12. Banks generally use the lower of the two numbers to determine how large a loan to offer you.

Special Considerations

Qualification ratios are not rigid. Excellent credit history often mitigates 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.

Credit Card Debt and Qualification Ratios

Credit card debt also counts toward your back-end ratio, but this is much more 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.

Most lenders now look at the borrower’s total revolving balance and apply 5% 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. 

Example of a Qualification Ratio

Here's a hypothetical example to show how qualification ratios work. Let's say you and your spouse earn a combined $96,000 a year, your family's gross income would amount to $8,000 a month. Multiply $8,000 by the 28% threshold required by most lenders and you’ll get the minimum housing expense that you can afford, which lenders call the front, or front-end ratio. In this case, your family would be eligible for a loan if total monthly housing expenses do not exceed $2,240. Note this expense figure includes property taxes, homeowner’s insurance, private mortgage insurance (PMI), and charges such as condo fees. 

Now let's take a look at the back-end ratio using the same example. In this case, take the $8,000 monthly income and multiply it by the minimum threshold of 36%. This is effectively your debt-to-income ratio, and you'll get a figure of $2,880. Next, deduct any monthly debt payments from that $2,280. Let's assume these 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 typically lower than the front-end ratio.

Related terms:

Back-End Ratio

The back-end ratio indicates what portion of a person's monthly income goes toward paying debts. read more

Credit History

Credit history refers to the ongoing documentation of an individual’s repayment of their debts. read more

Creditworthiness

Creditworthiness is how a lender determines that you will default on your debt obligations or how worthy you are to receive new credit. read more

Credit Score: , Factors, & Improving It

A credit score is a number between 300–850 that depicts a consumer's creditworthiness. The higher the score, the better a borrower looks to potential lenders. read more

Credit Card

Issued by a financial company giving the holder an option to borrow funds, credit cards charge interest and are primarily used for short-term financing.  read more

Credit Report

A credit report is a detailed breakdown of an individual's credit history, provided by one of the three major credit bureaus. read more

Debt

Debt is an amount of money borrowed by one party from another, often for making large purchases that they could not afford under normal circumstances. read more

Default

A default happens when a borrower fails to repay a portion or all of a debt, including interest or principal. read more

Down Payment

A down payment is a sum of money the buyer pays at the outset of a large transaction, such as for a home or car, often before financing the rest. read more

Debt-to-Income (DTI) Ratio & Formula

Debt-to-income (DTI) ratio is the percentage of your gross monthly income that is used to pay your monthly debt and determines your borrowing risk. read more

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