Debt-to-Income Ratio Explained
Your debt-to-income ratio is one of the most important numbers in your financial life. Although you may not know what yours is, it affects you whenever you try to buy something. Lenders obey strict debt-to-income ratio guidelines when determining whether you are creditworthy or not. It could be the difference between getting the house of your dreams or not.
What Is Debt-to-Income Ratio?
Calculating your debt ratio is actually easier than you may think. Lenders can come up with the number pretty fast once you have filled out a home loan application and given them the authorization to pull your information. The number represents how much debt and expenses you actually pay on a given month. It takes into consideration things like your house payment, taxes, insurance, interest, car payments, credit cards, and more. The more money going out each month, the less likely you are to fit the ratio guidelines.
Your debt ratio is made up of two numbers. The first number is referred to as the front ratio. The front ratio is made up of money that goes towards housing costs. This includes your house or rent payment as well as several other factors. If you own a house, you are also paying taxes and insurance towards the property. This amount goes into the front ratio as well. Interest that you pay for the loan also goes into this number. If you live in a subdivision with a homeowner's association, the dues for this will also be applied to the front ratio. Anything that has to do with your housing is part of it.
The back ratio is the total amount that you pay towards debt every month. This actually includes the numbers from the front ratio as well. In addition to the housing costs, they consider all consumer debt. Your car payments, credit cards, boat payments, and student loans are all part of this number. Any other recurring costs are also included. Child support, alimony, and any judgments against you count towards your back ratio.
What it Means
Now that you know the two components of the debt ratio, how are they used? The bank has certain acceptable ratios that they use to approve buyers. A common ratio is 28/36. Say that your gross income is $5000 per month. The bank would then calculate $5000 multiplied by .28 for the total that you can spend on housing. They would then multiply $5000 by .36 to determine what your total debt payments can be. In this example the first number would be $1400 and the second would be $1800. This means that the most you can spend on housing is $1400 and the most you can spend on total debt payments is $1800. If you exceed these ratios, the bank will not want to lend you the money that you need. If you fail to fit the standard debt ratio provided by your lender, there are other options to get a home loan. There are programs with higher debt-to-income ratio standards, but you will often pay more interest. If you do not understand any part of the debt ratio process, do not be afraid to ask your lender for an explanation.