The 5 W’s of Your Debt-to-Income Ratio

Posted by Chris on February 04, 2016

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Are you ready to buy a home? Comparing mortgage lenders? Considering a refinance? Well, your debt-to-income ratio is a huge factor in determining whether you can. Let’s dive into what your debt-to-income ratio is, who calculates it, why it matters, when you need it and where you can improve it – the 5 W’s of your debt-to-income ratio.

WHAT is debt-to-income ratio?

Debt-to-income ratio is the amount of debt you owe in relation to your monthly wage. Your debt-to-income ratio is a way for lenders to measure your ability to manage payments you make every month in order to repay money you have borrowed. Studies about mortgage loans have shown that borrowers with a high debt-to-income ratios are more likely to have issues making their monthly payments than those who have a low debt-to-income ratio.

The number 43 is important to take note of, because the 43 percent debt-to-income ratio is generally the highest ratio a borrower can have to still qualify for a mortgage loan.

There are two different types of debt-to-income ratios that lenders look at when you apply for a mortgage:

#1: The Front-end ratio – This is also called the housing ratio. It shows what percentage of your income is allotted to go towards your housing expenses, which includes your monthly mortgage payment, real estate taxes, homeowner’s insurance and association/HOA fees.

To determine this ratio, add up your housing expenses and divide it by how much you earn every month before taxes. Multiply the answer by 100. For example, if your housing expenses are $1000 and your monthly income is $4000, your front-end ratio is 33%.

#2: Back-end ratio – This shows what portion of your monthly income is dedicated to cover all of your monthly debt obligations, which includes credit card bills, car loans, child support, student loans and any other debt you may owe that shows on your credit report that requires monthly payments, along with your mortgage payments and other housing expenses.

To determine your back-end ratio, add up all of your monthly debt expenses along with your housing expenses and divide the answer by your monthly gross income. For example, you pay $200 a month for your car loan, $50 a month for student loans and $100 a month for your credit card bill. This all adds up to equal $1350 in monthly debt, including your housing expenses. If your monthly income is $3000, your back-end ratio equals 45%.

WHO calculates it?

So how is your debt-to-income ratio calculated? First, add up all of your monthly bills and monthly debt payments and divide them by your gross monthly income. Your gross monthly income is the amount of money you earn before taxes and other deductions have been taken out.

Here’s an example: If you pay $1500 a month for your mortgage and $100 a month for your car note and $400 a month for the rest of your bills, your total monthly debt payments are $2000. If your gross monthly income is $7,000, then your debt-to-income ratio is 35%, because $2000 is 35% of $7000).

WHY does it matter?

Just focusing on paying your bills on time, having a stable and high income and maintaining a good credit score won’t earn you a mortgage loan if your lender thinks you are too much of a financial risk. Regardless of your top tier job and high credit score, your debt-to-income ratio is what lenders use to determine whether you are too high of a financial risk. You need to know your debt-to-income ratio just as much as you need to know your credit score. Your debt-to-income ratio plays a huge role in qualifying for a mortgage loan.

Keep your eye on your credit score and be on the lookout for low interest rates, but stay focused on the big picture – your debt-to-income ratio. Lenders typically say the ideal front-end ratio is less than 28% and the back-end ratio should be at 36% or lower. Depending on your credit score, savings and the amount you can put on the down payment, some lenders may accept higher debt-to-income ratios, but the limits depend on the type of loan. For conventional loans, lenders focus heavily on the back-end ratio.

WHEN do you need to determine it?

You need to calculate your debt-to-income ratio prior to speaking to a lender and definitely before having your heart set on your dream home with the high price tag. Knowing your debt-to-income ratio can help you better understand your qualifications for getting a mortgage loan. The most obvious way to decrease your debt-to-income ratio is to pay off a portion of your debt. Most people don’t have the money to do this when they’re in the process of getting a mortgage loan, because most of their savings will be put towards the closing costs and the down payment.

To solve this issue, you may seek out a co-signer. Borrowers often elect to have a cosigner who is a relative. These co-signers aren’t required to live in the home, but they have to show sufficient funds and a good credit score. Know your debt-to-income ratio before seeking out a mortgage loan.

WHERE can you improve it?

There are instances in which having a high debt-to-income ratio is warranted. If you are actively paying off your debt, it makes sense to have a high debt-to-income ratio, but if you are only making the minimum payment, this may be an issue. There are two ways to lower your debt-to-income ratio – increasing your income and paying off your debt.

Increasing your income may mean working more hours, asking for a raise or taking on another job – the higher your income, the lower your debt-to-income ratio will be. Once your debts are paid off, your ratio will dramatically decrease. Although, paying off your debt means higher monthly payments or making extra payments.

Thinking about refinancing? Contact Lenda today for a free quote or for more information! We are always here to help you navigate the process with ease.

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Topics: Mortgage 101, Saving Money