What Does Debt-to-Income Ratio Mean?
If you have never purchased a home before it can be intimidating and confusing to learn all of the new terms and information you need to know in order to be aware of the home buying process. One thing all mortgage companies consider when giving a loan is your debt-to-income ratio. It is important to know what debt-to-income ratio is and how it affects the amount you can borrow from the bank to purchase a home.
The basic definition of debt-to-income ratio is: how much do you owe compared to how much you earn? You can calculate this monthly or annually depending on your income. People with a steady job usually calculate their debt-to-income ratio monthly, whereas self-employed people, whose income can be sporadic, may calculate their debt-to-income ratio annually. Mortgage lenders want to see how much money you make and compare it to how much debt you have in order to determine how high a mortgage payment you can afford. By calculating your debt-to-income ratio, the lender can pre-qualify you for a loan amount based on what they know you can afford to pay monthly.
To determine your debt-to-income ratio you can give the lender all of your information and let them do it for you, or you can go to one of the many debt-to-income ratio calculators offered at various websites and input your information to find out how much you qualify for in a mortgage loan. To determine your debt-to-income ratio you need to know:
- Your monthly minimum debt payments. Some lenders include your current mortgage payments, but most are just looking at your other monthly payments like car payments, credit cards, and other loans.
- Your monthly gross income. If this varies take an average by looking at past years' tax returns.
- Divide monthly minimum debt by monthly gross income. For instance if your monthly minimum debt is $300 and your gross income is $3000 then your debt-to-income ratio is 10%. This means 10% of your income goes to your debt.
Lenders use this system to determine your financial eligibility for a loan. They like to see people with less than a 20% debt-to-income ratio in order to be in good financial health. Most lenders base their loans on debt-to-income ratio by taking your current debt-to-income ratio and looking at the difference between that amount and their maximum total monthly debt. The maximum total monthly debt is the debt-to-income ratio you will have including your mortgage after they give you a loan to buy a home. Take the example above--if you take home $3000 per month in pay and spend $300 per month on your car payment and/or credit cards, this makes your debt-to-income ratio 10%. The lender may offer a maximum total monthly debt rate of 40% which means you would be eligible to get a mortgage loan that will cost you $900 per month. The actual amount of the loan would vary depending on the interest rate.
Are you wondering how I came up with the $900 a month mortgage amount? The debt-to-income ratio is 10% for $300 monthly debt and a $900 mortgage is another 30% monthly debt, for a total of 40% debt-to-income ratio, which is the lenderís maximum total monthly debt rate that they are willing to offer you.
Now that you understand how the mortgage lender determines how much to loan you, it is important to understand that you may not be able to afford their offer. Just because the lender says you can borrow that much money does not mean that you should. Before you decide on a price range to shop for your new home in, write down all of your debt, your income, your other miscellaneous expenses, and your future wants and needs. This can change your debt-to-income ratio in the near future. Right now you may be able to afford this high of a mortgage payment but the lender doesnít know you plan to start a family soon and will go from two incomes to one. Or what if you have a really expensive hobby and plan to make a large purchase in the next year that will completely change your debt-to-income ratio? Keep all of this in mind when shopping for a mortgage.
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