Understanding Top and Bottom Debt Ratios in Income Property Underwriting

Understanding Top and Bottom Debt Ratios in Income Property Underwriting

When assessing a borrower's financial capability for property loans, lenders critically analyze two pivotal debt ratios: the Top Debt Ratio and the Bottom Debt Ratio. These ratios provide insights into whether a borrower can manage their obligations comfortably.

1. Top Debt Ratio

The Top Debt Ratio is calculated as follows: Top Debt Ratio = Monthly Housing Expense ➗ Gross Monthly Income

Monthly Housing Expense encompasses: 1st mortgage payment + Real estate taxes (annual cost divided by 12) + Fire insurance (annual cost divided by 12) + Homeowner's association dues (for condos or townhouses) + Second and third mortgage payments, if any.

P.I.T.I. (Principal, Interest, Taxes, and Insurance) is a term often used interchangeably with Total Housing Expense, though they aren't exactly identical; P.I.T.I. doesn't include homeowner's association dues.

Threshold: Traditional lending theory suggests that the Top Debt Ratio should not exceed 25%, meaning housing expenses shouldn't be more than a quarter of the borrower's income. However, lenders may stretch this to 28%, acknowledging that exceeding 25% could lead to budget strains.

2. Bottom Debt Ratio

This ratio is broader in scope, defined as: Bottom Debt Ratio = (Total Housing Expense + Debt Payments) ➗ Gross Monthly Income

Debt Payments include: Car payments + Charge card payments + Payments on installment loans (e.g., appliances) + Payments on personal loans

Exclusions: Utilities (like PG&E, water, or telephone) and payments on real estate loans are not counted as "debt payments". However, net cash flow from rental properties is considered; positive cash flow augments gross monthly income, while negative cash flow is added to the numerator of the Bottom Debt Ratio.

Threshold: The acceptable standard for the Bottom Debt Ratio is generally 33.33% or 1/3, indicating that housing and debt expenses should not surpass one-third of the borrower's income. Lenders may occasionally stretch this to 36%, and some even to 40% or more, though higher ratios significantly increase lending risk.

In income property underwriting, these debt ratios offer lenders a structured approach to evaluate a borrower's financial health. While there are benchmarks for these ratios, they are often adjusted based on individual circumstances, balancing the need for caution with financial flexibility. However, exceeding these thresholds generally indicates increased risk, requiring careful consideration by both lenders and borrowers.

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