When you’re applying for a loan, one of the most important factors in determining your final mortgage amount is your debt-to-income ratio. Learn more about this percentage and why it’s so important.
Your debt-to-income ratio is the percentage of your monthly gross income that is used to pay your monthly debts including housing. It’s important because it’s an indicator of how much of your income is already spoken for each month, and in the eyes of the lender this percentage will determine if you have enough cash flow to pay the expenses that come with being a homeowner.
There are two debt-to-income ratio calculations:
Front-end ratio — Shows how much of your gross monthly income would go towards your mortgage payment. A rule of thumb is that your monthly mortgage payment should not exceed 28% of your gross monthly income. This would include:
• Mortgage principal and interest
• Property taxes
• Mortgage insurance premium
• Homeowners insurance
• Homeowners association fees
Back-end ratio — Shows how much of your gross income would go towards all of your debt obligations. Rule of thumb is that this should not exceed 36% of your gross income. This would include:
• Car loans
• Child support
• Credit card bills
• Student loans
• Condo fees
The lender will continue to look at your debt-to-income ratio until the mortgage approval is finalized. This means that once you’ve applied for a loan, it’s important not to change your debt-to-income ratio. Your ratio could change by making other large purchases, such as a car, furniture or appliances.
George, a Certified Public Accountant, explains: “If somebody comes to me after they’ve been approved for a home loan or wants to add additional credit, buy a car, buy some furniture, before the home closes, I always advise them not to do that. They’ve been approved on a debt to equity ratio or debt to income ratio that they have, and if they change that when they go to close, they may not qualify anymore, and they may lose the house that they want.”
MICHAEL: Debt to income ratio is a combination of all your debts, so your installment loans, such as a car payment or maybe a boat payment, plus a combination of all your revolving debts, which would be a credit card; and you’re going to divide that by your gross income that you receive each month, and that’s going to give us a percentage, and that’s going to be your debt to income ratio.
MICHAEL: It ensures that there is a low enough risk to where it works for both the bank and yourself. That way, you’re not spending too much money on your home and you’re not taking away from your other monthly expenses.
GEORGE: If somebody comes to me after they’ve been approved for a home loan or wants to add additional credit, buy a car, buy some furniture, before the home closes, I always advise them not to do that. They’ve been approved on a debt to income ratio that they have, and if they change that when they go to close, they may not qualify anymore, and they may lose the house that they want.