Your Debt-to-Income Ratio and Mortgages

Do you plan to apply for a mortgage? One of the most important numbers involved in the mortgage process is your debt-to-income ratio. What is your debt-to-income ratio? What should your goals be in order to qualify for a mortgage? And how can you reach those goals? Here's what you need to know.

What Is a Debt-to-income Ratio?

Debt-to-income ratio is the percentage of your monthly income that is currently used to pay debts. The calculation is fairly simple. You add up your monthly debt payments and then divide these by your monthly income. A person with $3,000 income each month and $500 in debts has a roughly 16% debt-to-income ratio.

However, actually doing this calculation can be tricky. If your income fluctuates, you may need to use an average over a period of several months. On the debt side of the equation, you should use mandatory minimum payments, even if you often pay extra to some debts. Generally, you would include all debts that are listed in your credit report plus any unusual ones such as alimony or child support.

What Should Your Ratio Be?

While every mortgage lender has slightly different standards, there are some guidelines for an ideal debt-to-income ratio. Most lenders consider the best ratio to be anything under 36% of your gross income. An acceptable ratio may allow you to have debt up to 43% and still get significant approval. Ratios over 50% will make qualification hard.

In addition, many lenders calculate how much of your income would be taken up by the proposed mortgage and related housing costs (like taxes). This ratio may need to be less than 28% in order to qualify for the best rates.

How Can You Reduce Your Ratio?

Do you need to reduce your ratio? If so, there are generally two ways to do it: reduce debt or raise your income. This may sound daunting, but there are some clever ways to do it. When was the last time you requested a raise or renegotiated some aspect of your compensation? If it's been a while, this is an easy way to raise income without more work.

If paying down all your debt before going house hunting is not possible, apply some other tricks to help lower your overall debt number. Consider, for instance, consolidating multiple loans into one signature loan with a lower payment than the previous minimum payments added together.

You might also analyze which debts could provide the biggest bang for the buck. If you pay off several small debts rather than one large one, you get rid of more minimum monthly payments and see a bigger drop in your ratio. And, although it may seem counterintuitive, paying more on lower interest loans can result in a smaller balance and lower payments faster than paying a higher interest loan.

Finally, look for ways to create a lump sum to apply on a one-time basis. Sell unused items, return purchases to stores, apply a bonus or tax refund, or ask for cash for the holidays. The goal is to get that ratio below the needed threshold, and a lump sum can do it quickly and easily.

Where Can You Learn More?

Want to know more about your debt-to-income ratio? Start by learning how it affects the types of mortgages you may seek and what lenders in your area expect to see. Cornerstone Residential Mortgage can help. We will work with you to get the answers you need to prepare in the best way possible for your mortgage qualification. Contact us today to speak with a mortgage pro from our office.