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Commercial Debt Ratios
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:
-
Top
Debt Ratio
-
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 he/she owns a home, the total of
the following:
-
1st mortgage payment on home
-
Real estate taxes (annual
cost/12)
-
Fire insurance (annual
cost/12)
-
Homeowner's association dues
(if the home is a condo or townhouse)
-
Second mortgage payment (if
any)
-
Third mortgage payment (if
any)
You will often hear the term “PITI.”
It refers to (P)rincipal, (I)nterest, (T)axes
and (I)nsurance. While PITI 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
his/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:
-
Car payments
-
Charge card payments
-
Payments on installment
loans, for example - a payment on a washer &
dryer that the borrower purchased
-
Payments on personal loans,
for example, a signature loan from the
borrower's bank
What is not included in "debt
payments" is Utilities such as PG&E, water or
telephone and payments on real estate loans.
Real estate loans are usually offset first by
the net rental income from the property. If the
borrower has a net positive cash flow from all
his rentals, then the net income is usually
added to his "gross monthly income." If the
borrower has a net negative cash flow from all
of his rental properties, then the amount of the
negative cash flow is usually added to the
numerator of the "bottom" debt ratio as if it
were a monthly debt obligation, like a car
payment.
Traditional lending theory
maintains that a borrower's "bottom" debt ratio
should not exceed 33 1/3%. In other words, the
total of the borrower's housing expense and debt
obligations should not exceed 1/3 of his income.
Lenders often will stretch on this ratio to as
high as 36%, and some have even been known to
stretch as high as 40% or more. Obviously a loan
with a debt ratio of 40% is a far more risky
loan than a loan with a debt ratio of 32%.
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