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Debt-to-Income Ratios Explained

During the process of acquiring a home loan, the phrase “debt-to-income ratio” is thrown around a lot. It’s a very important equation that allows the lender to determine whether or not a borrower can feasibly afford to repay a loan. Debt is a part of life. Most of us have it, and not all debt is bad debt. A mortgage is a debt obligation and often propels peoples’ financial futures. Car loans, while they don’t necessarily help our financial picture, are often essential in our lives. The same goes for student loans and any other monies owed. When a mortgage lender pulls a client’s credit report, he or she is able to see the bigger picture of debts owed. The loan officer adds up each and every monthly debt obligation, including any child support and monthly/minimum credit card payments. (As a side note, if you use a credit card regularly to pay for everyday items such as groceries and gas and subsequently pay that credit card off in full each month, the minimum monthly amount due on that card still appears on a credit report as an obligation unless there is no balance). In addition to existing monies owed, the loan officer then must add any monthly obligations that will be associated with the new home purchase, to include the mortgage principal and interest, taxes, insurance, and any HOAs or monthly assessments. Note that utilities are not taken into account as a monthly debt obligation. Once the loan officer determines a borrower’s entire proposed monthly debt obligation, including the potential new home’s expenses, she can figure the debt-to-income ratio. Of course, she must first have an accurate number for a borrower’s monthly income, which is gathered from all records of income, such as w-2s and paystubs, pension income, tax returns, and so on. The debt-to-income ratio is figured by dividing a person’s total monthly debt obligations by his total monthly income. The number, usually a percentage, is then used to determine if the borrower qualifies for the loan. Most investors have an allowable threshold for debt-to-income, such as 45% or 47%. It’s important to note that debt-to-income ratios can be figured as a total household number if more than one borrower is applying for the loan. In that case, all borrowers’ debts are figured with all parties’ incomes. To illustrate, Sally and Joe are applying for a loan. Sally earns $5,000 per month, and Joe earns $4,800 per month. Their total debt obligations before their new mortgage are $2,400 per month, and the expenses on their new home, including mortgage, taxes, and insurance are $1,800 per month. Their proposed debt ($2,400 + $1,800=$4,200) is then divided by their total income ($5,000 + $4,800=$9,800), or $4,200/$9,800=42.9%. Sally and Joe’s debt-to-income ratio is 42.9%. This ratio will help determine the right mortgage fit for Sally and Joe. When lenders pre-qualify a borrower for a proposed mortgage amount, they are able to use allowable debt-to-income ratios and work backward in order to determine an appropriate mortgage amount a borrower will qualify for. For instance, if a borrower is trying to use an FHA loan that allows a 56% debt-to-income ratio from a particular investor, then the lender can use that upper limit to determine how much of a mortgage the borrower may be awarded, taking into account other expenses, such as taxes and HOAs. As a strategy, it’s usually good practice to apply for loans that are under the upper limit of the debt-to-income ratio. By remaining slightly below an allowable ratio, based on the mortgage product or program, the borrower has “room,” so to speak. If anything arises during the transaction, such as a new debt, the borrower may still have a chance at acquiring the new loan.