What is your debt-to-income ratio, and why is it important when you’re applying for a mortgage? After all, it’s a term you’re almost guaranteed to hear during the mortgage application process. This short article will cover the basics of what it is, why it’s important, and what’s considered a good ratio to strive for.
What is a Debt-to-Income Ratio?
This is a number used to help lenders determine your ability to pay the debts you owe. Even though several types of lenders use it, it’s most commonly used in the mortgage industry.
The ratio is calculated by dividing your monthly debt payments by your gross income. So for example, let’s say your monthly debt payments (including the loan you’re applying for) comes out to $2,000 and your gross income is $6,000. Divide $2,000/$6,000 and you get 0.33 as your ratio of gross income to debt.
In other words, that means 33% of your income is going towards paying off debt every month. This debt can include a number of things:
- Mortgage
- Credit cards
- Lines of credit (such as a store)
- Car loans
- Student loans
Even though all of these debts are a bit different, they have monthly requirements and thus affect your score.
Why is Debt-to-Income Ratio Important?
Lenders see this as an important metric to help them determine if you’re able to pay them back. Since they’re in the business of making money, they don’t want to give out loans to someone who can’t make the monthly payments and ends up in default.
Let’s use two examples to illustrate how this can work.
John Doe makes $5,000 a month in gross income and will have $2,500 a month in total debt payments if the loan is approved. $2,500/$5,000 = 0.50.
On one hand, it may seem like they make more than enough money to make the payments. After all, they have about $2,500 left over at the end of the month, right? Not so fast- remember the debt-to-income ratio is based on gross income, not net income. In other words, other large expenses like taxes and health insurance aren’t accounted for. Taxes alone can wipe out about $1,500 of that remaining income. Plus you have other living expenses like food, gas, car insurance, utilities, etc.
That’s why the ratio is important. It helps the lender get an idea of how much money the borrower has available to spend on other things vs. paying off the debt.
What is a Good Debt-to-Income Ratio?
Every lender is different, but in general you should aim for a ratio of less than 36%. That’s the number to shoot for to get the best rates. If your ratio exceeds 43%, you may be declined the mortgage altogether.
Keep in mind that a lender doesn’t want to see more than 28% of your gross income taken up by a mortgage. So if you make $5,000 a month as gross income, lenders would prefer your mortgage to stay under 0.28 * $5,000 = $1,400.
Conclusion
Do you have any other questions on getting a mortgage? We are here to help, reach out to one of our Art of Homeownership Professionals today.
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