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Debt-to-Income Ratio

Finance
Can you afford a home? How to calculate your debt-to-income ratio

Baseball, hotdogs, apple pie, and – debt? Chevrolet almost got it right with its 1975 TV ad, but they forgot to mention perhaps the most American hallmark of all. Whether it’s a car payment, student loans, or a sky-high credit card balance, most of us find ourselves in debt at one time or another. In fact, the average adult with a credit file now has over $50,000 worth of total debt. Ouch.

If you’re amongst the millions of Americans who know the debt struggle all too well, you may be wondering if you can afford a mortgage on top of all your other financial obligations. Guess what? Your potential lenders will be pretty interested, too. In particular, mortgage lenders will look at your debt-to-income ratio to evaluate how much additional debt you can handle.

To calculate your debt-to-income ratio, simply add up all of your monthly debt payments and divide the sum by your gross monthly income. Your gross monthly income is typically the amount of money you earn before taxes and other deductions (health insurance and 401k contributions) are taken out.

Mortgage lenders will look at your debt-to-income ratio to evaluate how much additional debt you can handle.

For example, let’s say your student loan payment is $550 per month, your car payment is $350 per month, and your minimum credit card payments total $500 per month. Add in $200 for other monthly debts, and your total monthly debt payments are $1,600. If your gross monthly income is $5,000, then your debt-to-income ratio is 32 percent ($1,600 is 32% of $5,000.)

Now more than ever, lenders want to be absolutely certain that homebuyers have the means to repay their loan obligations. It is for this reason that 43 percent is the highest debt-to-income ratio a borrower can have and still obtain a Qualified Mortgage.

As with most things, however, there are exceptions to this rule. For instance, a small creditor can offer a Qualified Mortgage to a borrower with a debt-to-income ratio higher than 43 percent, but they still must consider your debt-to-income ratio in making their decision. Additionally, lenders don’t have to comply with the Qualified Mortgage standard. They are given strong incentives to do so — but they are not forced.

That being said, it’s never a bad idea to make an effort to lower your debt-to-income ratio. You can do this by either increasing your monthly income (take on a second job or ask for a raise), or by reducing your monthly debt (pay off credit cards or refinance your loans to lower your monthly payments). Not only will this give you an advantage when shopping for a mortgage, you’ll have more money left over to save for your emergency fund and other expenses.

When thinking about whether or not you can afford to buy a home, don’t automatically dismiss the idea simply because you carry debt. It depends more on whether your income stacks up against your debt in a way that makes lenders confident you’ll be able to repay your loan in full and on time.

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Kate Kasbee
Kate Kasbee is a blogger and freelance copywriter living in Los Angeles. She has a background in real estate marketing and has also written about a variety of subjects including pet care, how to adopt a vegan diet, and technology. Prior to living in sunny California, Kate spent eight years in Chicago where she lived in nine different apartments in five different neighborhoods. Though she’s not quite done exploring, Kate dreams of planting her roots and owning a home with creaky floors and plenty of land for starting an organic farm.
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