Investment Glossary – Debt-to-Income Ratio
Hike up you Urkel pants, get out your calculators, and sharpen your pencils. It’s time for some math.
The debt-to-income ratio is one of the basic tools used by lenders to determine whether or not they want to loan you money to buy a house. While there are more complex parts of the mortgage underwriting process that go on behind the scenes, this is one of the first things lenders will look at, and it’s a good gauge for you to use as well when you’re trying to figure out how much to spend on a home.
So what exactly is a debt-to-income ratio?
Simply put, it’s a measure of how much of your gross monthly income goes or would go to debt. The math is pretty straightforward. Take your salary for the year before taxes or any other paycheck deductions. Divide it by 12. That’s your monthly gross income. So if you earn $60,000 per year, your monthly gross income is $5,000 per month. Round numbers are nice. If you earn $55,000 per year, your monthly gross income is $4,583.33, which isn’t as easy to write, but does give you another example of how the math works.
From there, lenders look at any debt that you may already have outstanding. Maybe you have a car payment that is $300 per month, or a student loan payment of $175 per month. And maybe you haven’t quite kept up with your credit card bill, so there’s another $50 per month on that end too. Combined, that totals $525 per month. To figure out your current debt-to-income ratio, you divide your monthly required debt payments by your monthly gross income. In the case of making $5,000 per month, your current debt-to-income ratio would be 10.5%. If you were making $4,583.33 per month, it would be 11.5%.
Mortgage lenders can lend up to a 43% debt-to-income ratio in order for a mortgage to still be categorized as what is known as a Qualified Mortgage. However, just because they are willing to lend you that much doesn’t mean it’s a good idea for you to max out your debt on a house. It can put you in a tough position if your financial position changes. There’s no point in maxing out your budget to buy your dream house if you have to leave it six months later because you lost a job or you had other unexpected expenses.
There are a couple other wrinkles with regards to the debt-to-income ratio.
Commission income and income earned as a contractor is typically discounted by a lender, with them requiring two years of tax returns to see what the trend looks like for this income, and whether it is likely to continue. This is because these forms of income can be subject to greater variation than base salary. Keep this in mind as you build your budget prior to buying a house. You may have taken home $30,000 in commission income this year since you had a great year, but if last year wasn’t so hot, the bank is likely going to factor that in as well.
Debt-to-income ratios are a good way for you to get a handle on your housing budget and figure out the price range that makes the most sense for you. Make sure you are also aware of taxes and insurance costs that you’ll pay, as they’re going to impact your budget.
Now, Urkel pants off, regular pants on. Class dismissed.