Particularly if you’re applying for a mortgage, the question of how well you’re managing your debt to income ratio may come up. A good ratio improves your chances of being approved for a mortgage, while a poor ratio can disqualify you. Here’s what this ratio means.
Your Debt to Income Ratio
Your ratio is a measure of how high your debt payments are (or how high they will be) in relation to your income. It gives lenders an idea of how well you’ll be able to keep up with your mortgage payments. Someone whose debt payments make up a low share of her income, meaning she has a low debt to income ratio, is likely to be able to make payments on time. Someone whose ratio is higher is at risk of not paying his debts. It’s important to compare the size of debt payments to a person’s income, because the same payment could be affordable to one person and too high for another person who earns less money.
How the Ratio Is Calculated
There are two ways to calculate the debt to income ratio, as Bankrate notes. The first focuses on housing expenses. It adds together your mortgage principal, interest, and other expenses like real estate taxes to get your monthly housing expenses, and it then divides this number by your monthly income before taxes. This is known as the front-end ratio. The second way adds together your monthly mortgage payment and payments for other debts like credit cards, and it divides the sum by your monthly income before taxes. This calculation shows how your income compares with all your debts, not just those related to housing, and it’s called the back-end ratio.
How It Affects You
In general, you want your debt payments to take up as small a share of income as possible so you can afford them easily. And when you buy a house, lenders consider what your ratio would be with a proposed mortgage before deciding if you’re eligible for it. The L.A. Times explains that the front-end ratio should be less than or equal to 28 percent to get approval. The back-end ratio includes more categories of debt and thus has a higher limit of 43 percent. You may be able to get a mortgage with a higher ratio if your finances are in good shape, but lenders usually only allow exceptions if they have very good reason to think you’ll be able to afford it.
What You Can Do
If your ratio is high, there are things you can do to lower it. Paying off your debts early will make the ratio more manageable, although it’s easier said than done when debt payments already take up a high proportion of your income. Another strategy is to establish an emergency fund or build a bigger fund so that you are less likely to have to borrow. This won’t reduce your ratio immediately, but it will help you avoid going further into debt, which would drive your ratio higher. Increasing your income improves your ratio too, so taking a second job or switching to a higher-paying field will help.
If your debt to income ratio is preventing you from obtaining a mortgage, it will probably take some time to bring the ratio down. As you take steps to improve the ratio, you can look for a less expensive property or postpone buying a house until you’ve paid off some debts.
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