Understanding Debt-to-income Ratios

Financing

When the time has come, and you’re ready to buy a house, you will certainly hear a lot of “jargon”. One term you’ll hear a lot is debt-to-income ratio. This may sound a little intimidating, but it doesn’t need to. Debt-to-income ratios are simple to figure, and  you can use it to your advantage.

Your debt-to-income ratio is, simply put, is the way that lenders decide how much money you can afford to borrow. It is the percentage of your monthly gross income (before taxes) that is used to pay your monthly debts (not your living expenses). Two calculations are involved, a front ratio and a back ratio, written in ratio form, i.e., 33/38.

What the Numbers Mean

The first number indicates the percentage of your monthly gross income used to pay your housing costs, such as mortgage payment, taxes, insurance, insurance and homeowners’ association dues. The second number indicates your monthly consumer debt, such as car payments, credit card debts, etc. Thankfully, other living expenses are not considered debt.

A debt-to-income ratio of 33/38 means that 33 percent of your monthly gross income is used to pay your monthly housing costs, and 5 percent of your monthly gross income is used to pay your consumer debt—so your housing costs plus your consumer debt equals 38 percent.

33/38 is a commonly used guideline for debt-to-income ratios. Depending on your down payment and credit score, these can be looser or tighter, and also vary according to programs. The FHA, for instance, requires no better than a 29/41 qualifying ratio, while the VA guidelines require no front ratio but a back ratio of 41.

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Debt to Income Ratios 

Debt-to-income ratio not only affects your ability to buy a home, but other purchases as well. Debt-to-income ratios are powerful indicators of your creditworthiness and financial health. You should know your ratio and keep it low. Your consumer-debt number should never go higher than 20 percent. If you let it rise above 20 percent, you could:

• jeopardize your ability to make purchases such as cars, homes, appliances
• not get the lowest interest rates and best credit terms
• have difficulty getting additional credit

It’s a good idea to calculate your debt-to-income ratio before you begin looking for a home. Get your credit in order so you can get the best credit terms, the lowest interest rate and the most house possible.

For more information about getting qualified to purchase your dream home, contact me!

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