What is a Debt-to-Income Ratio?
A lot of factors come into play when you’re applying for a home loan. You may be familiar with how your credit score can affect your rates, how important it is to build an emergency fund, and even what type of mortgage you’re looking for.
What you may not be familiar with is your debt-to-income ratio. But you should be, because it is one of the key factors that affects your mortgage loan approval.
If your debt-to-income ratio is too high, you may not get approved. Or if you do, you may have to pay higher interest rates than somebody with a lower ratio.
How to calculate your debt-to-income ratio
Your debt-to-income ratio is actually a pretty simply calculation. Essentially, it measures how much of your gross income goes towards making payments on your debt.
You can calculate your ratio by adding up the payments you make towards your debt and comparing that to what you earn.
For example, let’s say you pay $400 towards an auto loan each month and $100 towards credit card debt. Your monthly debt payments total $500. If you make $2,000 a month, then your debt-to-income ratio is 25%
The formula is simple: Total Debt Payments/Monthly Income X 100 = your ratio.
Note: Mortgage lenders will use your pre-tax, or gross income, when calculating your debt-to-income ratio.
Types of debt-to-income ratio
Many lenders will consider two different debt-to-income ratios when deciding whether to approve your mortgage loan, how much to lend you, and what interest rate you’ll receive.
1. Front-end ratio.
The front-end ratio considers how much of your monthly income will go towards all of the costs directly associated with homeownership. These include:
- Property taxes
- Homeowners insurance
- Principle and interest on your mortgage
- Any homeowner’s association fees
2. Back-end ratio
The back-end ratio considers how much of your monthly income will go towards all of the costs above plus your total debt obligations, such as:
While most lenders typically consider both types of ratios, the back-end ratio is usually more important since it presents a more accurate picture of your financial situation.
What is a good debt-to-income ratio?
Most lenders consider a front-end ratio of 28% and a back-end ratio of 36% to be low-risk. Some lenders may allow a back-end ratio of up to 43%, but this might mean you pay higher interest rates.
If you can get a loan through a government-backed program, such as FHA loans, your back-end ratio could be as high as 50%.
Learn more about the ideal debt-to-income ratio from the Consumer Financial Protection Bureau.
Why it's important
Knowing your debt-to-income ratio before you apply for a mortgage will help you get an idea of how much you can actually afford to borrow.
Additionally, if you find that your debt-to-income ratio is too high, you can take the appropriate steps to lower it before you apply for a loan. These steps include:
- Paying down loans
- Paying down credit card debt
- Eliminating most, if not all, of your debt
Remember, your ratio is key in determining how much you can borrow, what your interest rate will be, and whether or not you’ll even be approved. It’s important to try and get your ratio at a percentage that make lenders feel comfortable.
When it comes to buying a home, it’s important that you understand the process from start to finish. Make sure your financially prepared, and that you know exactly what you’re looking for in your home.
If you still have questions about the homebuying process, applying for pre-approval, or anything related to your first mortgage, our Real Estate Loan Officers are here to answer your questions.