Debt to Income Ratio for Mortgages - dummies

Debt to Income Ratio for Mortgages

By Eric Tyson, Robert S. Griswold

What is debt-to-income ratio? When you apply for a mortgage, your lender will take a hard look at your finances to determine your debt-to-income ratio. Lenders aren’t as concerned about short-term loans that you’ll pay off in fewer than ten months. They will, however, add 5 percent of any unpaid revolving credit charges to your monthly debt load.

For example, suppose you earn $4,000 per month. If your current monthly long-term debt plus the projected homeownership expenses total $1,200 a month, your debt-to-income ratio is 30 percent ($1,200 divided by $4,000).

If your debt-to-income ratio is on the high side, a lender puts your loan application under a microscope. Even if all your credit cards are current, the lender may insist as a condition of making the loan that you pay off and cancel some of your credit cards to reduce your potential borrowing power. Doing so reduces the risk of future default on your loan.

How to calculate debt-to-income ratio

Follow these simple steps to calculate your debt-to-income ratio:

  1. Add all of your monthly bills together.

    This includes what you pay out, but typically doesn’t involve your monthly utilities or grocery bills. It does include items, such as:

    • Rent or mortgage
    • Monthly loan payments
    • Car payments
    • Credit card debt
    • Any other debt payments
  2. Divide the total by your monthly income before taxes.

    The result in your debt-to-income ratio.

This number will help you evaluate the likelihood that your lender will finance your mortgage.

What is a good debt-to-income ratio?

Although this can vary depending on your lender, you typically want to shoot for a debt-to-income ratio of 35 percent or less. This level is usually considered to be manageable.

If you want to increase the odds of having your loan approved and accomplishing your financial goals, lower your debt-to-income ratio by paying off small loans and credit card debt and closing any unused open credit accounts prior to applying for a mortgage. An excessive number of open accounts reduces your credit rating.

Are you thinking you can handle excess borrowing? Some people believe they can handle more mortgage debt than lenders allow using their handy-dandy ratios. Such borrowers may seek to borrow additional money from family, or they may fib about their income when filling out their mortgage applications.

Although some homeowners who stretch themselves financially do just fine, others end up in financial and emotional trouble. You should also know that because lenders usually cross-check the information on your mortgage application with IRS Form 4506T (the lender receives your actual tax return you filed, which certainly didn’t overstate your income), borrowers who fib on their mortgage applications are caught and their applications denied.

So although the lender’s word isn’t the gospel as to how much home you can truly afford, telling the truth on your mortgage application is the only way to go. It may be painful to learn that you don’t qualify for the loan you need to purchase that home of your dreams, but you’re likely better off in the long run not overextending yourself with mortgage debt.

We should also note that telling the truth prevents you from committing perjury and fraud, troubles that catch even officials elected to high office. Bankers don’t want you to get in over your head financially and default on your loan.