Mortgage lenders use the debt-to-income ratio to evaluate the creditworthiness of borrowers. It represents the percentage of your monthly gross income that goes to monthly debt payments, including your mortgage, student loans, car payments and minimum credit card payments. The debt-to-income ratio does not take into account such big expenses as income taxes, health insurance or car insurance. Generally, lenders are looking for a ratio of 36% or lower, though it is still possible to get a mortgage with a debt-to-income ratio as high as 43%. Worried that you have too much debt to buy a house? Read on for more about what lenders consider the ideal debt-to-income ratio for mortgages.
How to Calculate Your Debt-to-Income Ratio
To calculate your debt-to-income ratio, add up your recurring monthly debt obligations, such as your minimum credit card payments, student loan payments, car payments, housing payments (rent or mortgage), child support, alimony and personal loan payments. Divide this number by your monthly pre-tax income. When a lender calculates your debt-to-income ratio, it will look at your present debt and your future debt that includes your potential mortgage debt burden.
The debt-to-income ratio gives lenders an idea of how you’re managing your debt. It also allows them to predict whether you’ll be able to pay your mortgage bills.
It’s important to note that debt-to-income ratios don’t include your living expenses. So things like car insurance payments, entertainment expenses and the cost of groceries are not included in the ratio. If your living expenses combined with new mortgage payments exceed your take-home pay, you’ll need to cut or trim the living costs that aren’t fixed, e.g., restaurants and vacations.
The Maximum Debt-to-Income Ratio for Mortgages
Currently, the maximum debt-to-income ratio that a homebuyer can have is 43% if he or she wants to take out a qualified mortgage. Qualified mortgages are home loans with certain features that ensure that buyers can pay back their loans. For example, qualified mortgages don’t have excessive fees. And they help borrowers avoid loan products – like negatively amortizing loans – that could leave them vulnerable to financial distress.
Banks want to lend money to homebuyers with low debt-to-income ratios. Any ratio higher than 43% suggests that a buyer could be a risky borrower. To a lender, someone with a high debt-to-income ratio can’t afford to take on any additional debt. And if the borrower defaults on his mortgage loan, the lender could lose money.
The Ideal Debt-to-Income Ratio for Mortgages
While 43% is the highest debt-to-income ratio that a homebuyer can have, buyers can benefit from having lower ratios. The ideal debt-to-income ratio for aspiring homeowners is at or below 36%.
Of course the lower your debt-to-income ratio, the better. Borrowers with low debt-to-income ratios have a good chance of qualifying for low mortgage rates.
Mortgage lenders want potential clients to be using roughly a third of their income to pay off debt. If you’re trying to qualify for a mortgage, it’s best to keep your debt-to-income ratio to 36% or lower. That way, you’ll improve your odds of getting a mortgage with better loan terms.
Tips for Getting a Mortgage
- The debt-to-income ratio is just one of several metrics that mortgage lenders consider. They also look at your credit score. If your score is less-than-stellar, you can work on raising it over time. One way is always to pay your bills on time. Another is to make small purchases on your credit card and pay them off right away.
- If you can’t get a mortgage for the amount you want, you may need to lower your sights for now. But that doesn’t mean you can’t have that dream home someday. To realize your housing hopes, consider hiring a financial advisor who can help you plan and invest for the future. Our matching tool will connect you with up to three advisors in your area.
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