Debt-to-income ratio. If you’re in the process of applying for a home mortgage, you may have come across this term but do you understand what it means and how it can affect the loan application process? The debt-to-income ratio is how lenders evaluate your borrowing habits. Here’s what the debt-to-income ratio means and why it’s important.
What’s debt-to-income ratio?
Simply put, the debt-to-income ratio is the total of all your monthly debt payments divided by your gross monthly income; it’s expressed as a percentage). Lenders use this number (along with your credit history) to determine your ability to repay a loan.
Calculating your debt-to-income ratio is simple: add your monthly debt payments – this includes credit card payments, car, personal, or student loans, and housing expenses (i.e. rent or your current mortgage payment if applicable). Next, divide that number by your gross – or pretax – income. Finally, multiply the decimal number by 100 and you’ll end with your ratio percentage.
Why is my debt-to-income ratio important?
Lenders and banks use your ratio to determine your ability to pay back your debts. They use the understanding behind your debt load to determine what their lending limits will be.
What’s a good debt-to-income ratio?
While the maximum debt-to-income ratio varies by lender, the lower your debt-to-income ratio the better. In general, a ratio of 35% or less is ideal. A ratio of 36% to 49% is acceptable but could be improved as your debt load could potentially become unmanageable. A debt-to-income ratio 50% and above will make it difficult to qualify for a loan.
How do I improve my debt-to-income ratio?
Is your debt-to-income ratio a bit higher than 36%? Thankfully it’s possible to reduce it. Here are some options:
- Increase your monthly debt payments. The extra payments will decrease your total debt.
- Avoid taking on additional debt. Its time to prioritize your debt. If buying a new home is your priority, avoid taking on additional debts.
- Postpone large purchase. Hold off on large-ticket items to save money so you don’t have to put the full amount on credit.
Take time to recalculate your debt-to-income ratio to see how your work is paying off. Watching your debt-to-income ratio decrease can be very motivating! Keeping your debt-to-income ratio low will help you qualify for a mortgage and keep your monthly payments low.
Ready to Buy a New Home?
Are you ready to buy a new home in Washington, Oregon, or Idaho? There’s a lot to navigate on the path to homeownership and we’re here to help. We invite you to reach out to us to learn more about your financing options.