By now, you’ve heard all about how your credit rating and score will affect your ability to get a mortgage with desirable terms and the lowest possible interest rate. There exists however, another important piece to the puzzle, and that is your current debt load. It is one thing to know that you’ve paid your past debts one time; but can you continue to do so if you take this new mortgage? Calculating what is called your debt-to-income ratio can give you (and your lender) an idea.
What is a Debt-to-Income Ratio? A debt-to-income ratio represents a percentage of your income that goes toward paying debts. Think of it as a snapshot of your spending habits. Calculating your debt-to-income ratio is very easy. Take a look:
- Monthly Income = $4,000
- Monthly Debt = $1,000
- Divide $1,000 by $4,000 to get .25
- Your debt-to-income ratio = 25%
What is Included in your Income Number Let us look in a bit more detail, how we calculated the monthly income number in the above example. Your debt-to-income ratio is best figured on a monthly basis. Your biggest source of income will most likely be your salary. Debt-to-income ratios are based on gross income (that is before taxes and insurance are taken out of your paycheck). To quickly calculate your monthly gross salary, do so with one of two calculations:
- Take your yearly income and divide by 12
- If you get paid biweekly (every other week), take one pay check’s gross pay and multiply it by 2.17
In addition to your monthly paycheck, include:
- Regular income from alimony and child support
- Averages of bonuses, commissions and tips
- Dividends and interest earnings
- Government benefits and assistance
- Income from a side business
- Other miscellaneous income
What is Included in Your Debt Number
Let us take a look at what is included in your monthly debt number:
- Rent or mortgage payment (including property taxes, insurance, private mortgage insurance and association fees)
- Car payment
- Minimum credit card payments (only minimum due; not balances)
- Student loan payment
- Child support and alimony
- Legal judgments
- Other monthly debt obligations
What is Not Included in Your Debt Numbers
- Food bills
- Entertainment expenses
- Informal personal loans
The Results – How to Interpret Your Number
Once you have calculated your debt-to-income ratio, refer to the following to view that snapshot of your spending habits and financial stability:
- 35% or less: a healthy debt load to carry for most people
- 36% – 42%: pay closer attention to your debt before problems arise
- 43% – 49%: take immediate action as financial difficulties may be imminent
- 50% or more: get professional help to aggressively reduce debt
How Mortgage Lenders Use Debt-to-Income Ratios
Mortgage lenders approach the debt-to-income calculation from the other direction. They strive to offer loans that will keep their customers within a specified debt-to-income ratio range. Your lender will use two different ratios to analyze your situation; one factors in only your new housing expense and the other uses your existing recurring debt plus your new housing expense.
he first type of ratio is what is known as a front-end ratio. This is the percentage allowed for housing expenses only. For conventional loans (we’ll see the limits for other loan types later) the front-end ratio limit is 28%. From our example above:
- Your monthly income is $4,000
- $4,000 times 28% = $1,120
- The maximum loan the lender should offer is one that converts to $1,120 per month in HOUSING ONLY debt.
So far, your lender has calculated a mortgage payment based on your income and housing debt. He will now turn his focus toward your other recurring debt. This can be a game changer. Your lender wants to make sure you can pay for your new loan and still pay for everything else. He will calculate what is called your back-end ratio. The back-end ratio is a percentage allowed for housing expense plus your other recurring debt. In our conventional loan example, a back-end ratio limit is 36%.
- Your monthly income is $4,000
- $4,000 times 36% = $1,440
- The maximum loan the lender should offer is one that converts to $1,440 per month in TOTAL debt.
- If the difference between the back-end and front-end amounts ($1,440 – $1,120) does not cover your other debts, the lender will need to lower the amount he can offer you.
Ratio Limits by Mortgage Type
The front-end and back-end ratio limits differ depending upon the mortgage type. Conventional loans are defined as any loan that is not backed by the federal government.
- Conventional loans: front-end ratio of 28 and back-end ratio of 36
- FHA loans: 31 and 43
- VA loans:: 41 and 41
- Jumbo, non-conforming loans: 45 and 55
The Way the Ratios are Written (and are Mistakenly Read)
In this article I have written the ratios as “28 and 36”. You will see however, the ratio is more commonly expressed as 28/36. This can be misleading. These numbers represent the front-end ratio and a back-end ratio. We are not looking at a fraction or dividing one number into the other. Though because we are talking about ratios, that could be anybody’s first impression.
- Try running your numbers based on net income (after taxes and insurance) to get a better picture of your situation
- Include all of your monthly expenses in your calculation (remember, the lender will only include formal, recurring debt)
- Run your own ratio before you meet with your lender. Read our article about being a responsible home buyer to see why.