Next to your credit score, your debt to income ratio plays a major role in your ability to secure a loan. Each loan program has a specific debt ratio they require. This doesn’t mean every lender abides by that rule. Some enforce stricter rules to help prevent default. Knowing how lenders calculate your ratio can help you best prepare for your loan approval.
Figure Out Your Debts
First, figure out your debts. This doesn’t mean the $20 you owe your sister or the money you pay to the electric company each month. Lenders care about the debts on your credit report. A few examples include:
- Credit card payments
- Installment loans
- Child support payments
- Alimony payments
- Payment arrangements for any federal/state government debt
You need the total of these monthly payments. If you have credit card debt, you can include the minimum payment required. If you don’t have a minimum payment, figure 1-2% of the balance as your minimum payment. Once you have the total, move onto the next step.
Figure Out Your Income
Lenders compare your total debts to your total monthly income. This is your gross income – not the net. This is good news because it means more income and a lower debt ratio. Lenders use different methods when calculating your income. The easiest scenario is if you make a regular salary. If you don’t, you’ll have a little more work ahead of you.
Here are a few examples:
Joe makes $40,000 per year on a salary. His W-2s and paystubs verify this fact. The lender then takes $40,000/12 = $3,333. This is Joe’s gross monthly income.
John makes $20/hour. He works an average of 40 hours a week, but some weeks he works a little more or less. His W-2 shows he made $41,000 last year and $42,500 the year before. A lender will take an average of the amount as follows:
$41,000+$42,500 = $83,500/24 months = $3,479 gross monthly income
Once you know your gross monthly income, you can move onto the next step of figuring out your debt to income ratio.
Determining the Debt to Income Ratio
Once you have the above 2 numbers, you determine your debt to income ratio. You divide the total liabilities by your gross monthly income.
Adding onto the above example, let’s say:
Joe has $400 in monthly liabilities. He applied for a loan with a payment of $900 per month including taxes and insurance. The lender determines his front and back end ratio as follows:
- Front-end ratio – $900/$3333 = 27%
- Back-end ratio – $400+$900/$3333 = 39%
Joe might not be eligible for a conventional loan since they allow a front-end ratio of 28% and a back-end ratio of 36%. However, he might make a great candidate for the FHA loan, which allows back-end ratios of up to 43%.
The Debt Ratio Isn’t the Only Issue
Don’t focus solely on your debt ratio, though. Yes, it’s a big deal, but not the only one. The lender looks at the big picture. Think of your credit score and your employment history. You could have the best debt ratio but the worst credit score. You wouldn’t qualify in this case. You could also have the best debt ratio but not have consistent employment. Each of these factors plays a role in your ability to secure a loan.
Lenders want to know that you can afford the loan, but also that you have good habits. A low credit score shows that you don’t pay your bills on time. It could also mean you overextend yourself. There are many variables that play into your credit score. The key is not focusing on one factor, but looking at the big picture.
Knowing how lenders calculate the debt to income ratio can help you get a head start. If you know your debt ratio is high, you can work it down. Start paying debts off or figure out how to increase your income. Maybe you need a 2nd job for a while. You’ll need it for at least 6 months before a lender can use the income. But it might be just enough to help push you into the approval zone.
As with any other issues, talk with different lenders. Each bank has their own threshold for risk. Some allow higher debt to income ratios than others. Figure out where you would do the best and stick with that lender. You may even find that two lenders give you two different answers for the same loan program. Shop around and find the deal that is right for you!Click to See the Latest Mortgage Rates»