Verified Answer :

  • The debt-to-income (DTI) ratio measures the percentage of monthly gross income spent on debt payments.
  • The 'front-end' ratio (housing costs) is typically capped at 28%.
  • The 'back-end' ratio (total debts) is typically capped at 36%.
  • The standard benchmark used in lending is the 28/36 rule, matching option d: \(\boxed{\frac{28}{36}}\).

Explanation

  1. Understanding the Debt-to-Income Ratio

The debt-to-income (DTI) ratio is a personal finance measure that compares an individual's monthly debt payment to their monthly gross income. It is a critical metric used by lenders to assess a borrower's ability to manage monthly payments and repay debts. Lenders typically look at two different ratios when evaluating mortgage applications.

  1. Industry Standard Benchmarks

In mortgage lending, there are two standard benchmarks:

  1. The 'front-end' ratio, also known as the housing ratio, calculates the percentage of gross monthly income that goes toward housing costs (such as mortgage principal, interest, taxes, and insurance). The conventional standard for this ratio is 28%.
  2. The 'back-end' ratio calculates the percentage of gross monthly income that goes toward all monthly debt payments, including housing costs and other debts like credit card payments, student loans, and auto loans. The conventional standard for this ratio is 36%.

These guidelines are often referred to as the 28/36 rule.

  1. Evaluating the Choices

Comparing the provided options to the industry standards:

A\(\frac{20}{28}\)
B\(\frac{20}{36}\)
C\(\frac{28}{30}\)
D\(\frac{28}{36}\)

Option 'd' directly corresponds to the standard 28% front-end and 36% back-end DTI ratio guidelines used in conventional mortgage lending. Therefore, the ratio used to determine one's debt-to-income limits is \(\frac{28}{36}\).

Examples

Imagine you are applying for a mortgage to purchase your first home. When the bank reviews your application, they calculate your monthly gross income and your total monthly debt obligations. By dividing your housing costs by your income, they check the 28% threshold. By dividing your total debt payments by your income, they check the 36% threshold. If your ratios fall within these benchmarks, you are more likely to be approved for a loan with favorable interest rates, demonstrating the practical application of the 28/36 rule in real-world financial decision-making.

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