Two of the most important terms used when applying for a mortgage whether it be a refinance or purchase transaction are DTI (debt-to-income) and LTV (loan-to-value).

What do they mean, how are they important, and how are they calculated to help qualify borrowers for a mortgage?

DTI: Debt-to-income ratio is the percentage calculated by dividing the borrower's monthly debts by their gross monthly income (income before taxes are deducted). For example, for a gross income of $5000 per month and debt payments consisting of mortgage or rent, a car payment, and credit cards of $2000 per month, divide the monthly debt (the $2000) by the gross monthly income (the $5000) to get a DTI of 40%. This is also called a back-end DTI. It's important to note that debts such as utilities, car insurance, and cable bills are not considered a factor when calculating DTI.

Front-End DTI: The front-end DTI is calculated the same way as the back-end DTI, however the front-end DTI only calculates debt related to the anticipated mortgage payment, which generally includes principal, interest, taxes, and insurance (PITI). Lenders will use both front- and back-end DTIs to determine what a borrower can qualify for and how much of a mortgage the lender can provide based on the resulting percentage.

The DTI calculates a borrower's ability to pay their mortgage. The higher the DTI, the higher the risk for the lender. As a result, higher DTIs traditionally carry higher interest rates whereas lower DTIs carry less risk and traditionally lower interest rates.

LTV: Loan-to-value ratio is calculated by dividing the current value of the home by the amount of the mortgage owed. For both purchase and refinance transactions, the lender will hire an appraiser to find out the current market value. Once this value is known, the lender will divide the anticipated mortgage amount into the appraised value to calculate the LTV.

Higher LTVs carry more risk. Should the borrower default, they leave the lender with little equity to recoup any losses, so lower LTVs are preferred.

Bottom line: Your loan officer can help explain in more detail how and why these calculations are important, what they mean to you, and how they can affect the type of mortgage you qualify for.

Source: Mortgage Market Guide