What is a Debt-to-income Ratio?
When you’re ready to buy a house, a lot of jargon is thrown around. One term you will hear frequently is debt-to-income ratios. Mortgage lenders use this ratio to calculate how much house you can afford. It is the percentage of your monthly gross income (before taxes) that is used to pay your monthly debts (not your monthly living expenses). Two calculations are involved, a front ratio and a back ratio, written in ratio form, i.e., 33/38. The first number indicates the percentage of your monthly gross income used to pay housing costs, such as principal, interest, taxes, insurance, mortgage insurance and homeowners’ association dues. The second number indicates your monthly consumer debt, such as car payments, credit card debt, installment loans, etc. Other living expenses are not considered debt.
A debt-to-income ratio of 33/38 means that 33 percent of your monthly gross income is used to pay your monthly housing costs, and 5 percent of your monthly gross income is used to pay your consumer debt—so your housing costs plus your consumer debt equals 38 percent. 33/38 is a common guideline for debt-to-income ratios. Depending on your down payment and credit score, the guidelines can be looser or tighter, and guidelines also vary according to program. The FHA, for instance, requires no better than a 29/41 qualifying ratio, while the VA guidelines require no front ratio but a back ratio of 41.
The debt-to-income ratio not only affects your ability to buy a home, but other purchases as well. Debt-to-income ratios are powerful indicators of creditworthiness and financial health. Know your ratio and keep it low. Your consumer-debt number should never go higher than 20 percent regardless. If you let it rise above 20 percent, you may:
- Jeopardize your ability to make major purchases—cars, homes, major appliances—when you need them;
- Not get the lowest possible interest rates and best credit terms;
- Have difficulty getting additional credit in emergencies.
A few good practices if you are considering applying for a mortgage to finance the purchase of your home:
- Calculate your debt-to-income ratio before you begin looking for a house;
- Get your credit in order so you can get the best credit terms and lowest interest rate;
- Know what your credit score is.
If you have any questions, please contact my office at (407) 405-6666. We are here to #NavigateYourOutcome.