Updated April 2020
When looking to open a new line of credit, 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 debt to income ratio improves your chances of being approved for a mortgage, while a poor ratio can disqualify you. Here’s what this ratio means to lenders.
Your debt to income ratio is a measure of how high your debt payments are (or how high they will be) in relation to your total 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 their income, meaning they have 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 their 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 if the ratio is high.
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.
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. In general, lenders consider a monthly housing debt of no more than 28% to 33% of your income and total debt of no more than 38% of your income acceptable. 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 good reason to think you’ll be able to afford it.
If your ratio is high, there are things you can do to lower it. Paying off your debts will make the ratio more manageable, although it’s easier said than done. If you are having trouble making the minimum payments on your credit accounts, it may be time to seek the help of an expert who can help you come up with a plan to get your finances back on track. Increasing your income improves your ratio too, so taking on a side-gig or a second job or finding a higher-paying position 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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