When a mortgage lender qualifies a borrower, they will examine income and monthly debts to see how much they can afford using a debt ratio. If you are wondering what a debt ratio is, and how it is calculated, take a look at this graphic and read on.
Mortgage Debt Ratios
A debt ratio compares monthly debts to income and then generates a number that is usually converted to a percentage. If your debt ratio is too high, you may not qualify for certain loan programs… or worse, may not qualify for a loan at all because of what you can afford!
Lenders will typically run two different debt ratio calculations. The “front-end” ratio will examine all debts except for your housing payment. The “back end” ratio will examine all debts and include a soon-to-be housing payment.
For the purpose of this introduction, the graphic below considers only the “back-end” ratio which includes the soon-to-be mortgage payment in the calculation.
Let’s also take a look at an example. Assume you earn $5,000 each month and have a student loan payment of $400 and a car payment of $250 each month as well. Your front end ratio will be $650/$5,000 = 13%. This number is far below the typical requirement of 31% for FHA loan front-end ratios.
Now consider adding in your new housing payment (including the mortgage payment, taxes, insurance, and mortgage insurance) of $1,500. Including this debt will generate a back end ratio of ($650 + $1,500)/$5,000 = 43%, the limit for most FHA back-end ratios.
Tip: Remember to use gross income when it comes to calculating what you can afford with a debt ratio. Gross income is the amount of income BEFORE taxes and other items, such as health insurance or 401k contributions, are taken out.
In part one of this series, we learned a bit about the relationship between the purchase price, down payment and loan amount of a purchase mortgage. Now that we have a better understanding of debt ratios, we will take a look at what actually makes up a mortgage payment – and it may be more than you think!
Related Posts in this Series
Part 1: What is a mortgage?