How do You Calculate Your Debt to Income Ratio?
Do you truly know how lenders will look at your financial history in order to decide whether or not to extend you a mortgage?
Have you heard that your debt to income ratio shouldn't be more than 36 percent of your total income?
Do you even know what your debt to income ratio is or how to calculate it?
If you’re like most people and are wondering “How do you calculate your debt to income ratio?” Don’t despair, simply follow the steps below and you'll soon know whether or not you're in a good position to apply for a mortgage loan.
What is your debt to income ratio?
Simply put, your debt to income ratio is the amount of monthly debt you pay out in contrast to how much income you have coming in.
How do you calculate your debt to income ratio?
Income:
We will start by figuring out the easy part of this equation – your monthly gross (before tax) income. For those of you who are on a structured paycheck simply calculate your monthly salary. If you have some type of varying income or work on a commission, then total up your last six month's earnings and divide by six. This is how much income you have coming in each month. Note: Only include income that would appear on your tax forms. Do not count unreported income.
Debt:
Next you need to figure out your total monthly debt. Add together the total costs of your credit card payments (only use the minimum amount payments for this calculation, even if you pay more), car payments, student loan payments, and any other monthly debt you currently have (e.g., child support payments, medical bills, your current mortgage if you are considering buying a second home), along with the estimated amount of your new mortgage payment. This is the amount of monthly debt you will be paying out each month.
Debt to Income Ratio = Debt/Income:
To calculate your debt to income ratio simple take your monthly debt amount and divide it by your total monthly gross (before taxes) income. Move the decimal point to the right two places, and you now have the percentage of your income that is debt.
Example: Your monthly debt payments total $800 a month, and your gross income is $2000 a month. Divide 800 by 2000 and you get 0.4 (800/2000 = 0.4). Move the decimal point to the right two places and you get 40%.
What does the debt to income ratio mean?
Now that you’ve done your calculations, what exactly does the percent you get mean? A debt to income ratio of 36% or less is considered financially healthy. The higher your debt to income ratio, the more unhealthy (i.e., risky) your financial health is. Although there are a few exceptions, the vast majority of mortgage lenders will want to see a debt to income ratio no higher than 36%. If your debt to income ratio is:
Less than 36%: You are considered financially healthy and are a good candidate for a home loan.
37% – 42%: You are able to get credit cards pretty easily, but it may be more difficult for you to get loans. If you want to get a mortgage loan, you are going to have to pay a higher interest rate, or reduce some of your debt first.
43% - 49%: Your financial health is in trouble. Although you may be keeping up with the bills, your debt to income ratio is on the high side.
50% or greater: You should talk with a non-profit financial counseling agency to figure out what you can do to reduce your debt.
If your debt to income ratio is so high that you will likely not be able to qualify for a home loan, you should pay down some of your debt before applying for a mortgage. Doing so will not only increase your chances to get a mortgage loan, but it will also ensure that you qualify for one with better terms and interest rates.
How do you calculate your debt to income ratio? It's not as hard as you think. By simply taking the total of your monthly debts and dividing it by your monthly gross income you'll know whether or not you're in a good position to apply for a mortgage loan.
____________________________________________________________________
