Infographic: Debt to Income Ratio Explained
What is a debt-to-income ratio?
Debt-to-income ratio is a percentage, a number that compares a buyer’s proposed housing costs and debt payments to their gross monthly income. Debt-to-income ratio is a metric that gives lenders a clear idea if a buyer will be able to afford future mortgage payments.
How is your debt-to-income ratio calculated?
Debt-to-income ratio is calculated by dividing monthly debt payments by monthly gross income. The resulting number is then given as a percentage. There are two forms of debt-to-income ratios: a “front-end” ratio and a “back-end” ratio.” The front-end ratio compares a buyer’s proposed housing and mortgage expenses to their gross income, the amount of money they earn each month before taxes and all payroll deductions. The back-end ratio measures the amount of a buyer’s gross income that goes toward major existing debt, including housing expenses.
What is a good debt-to-income ratio?
Lenders vary to some degree in what they consider an ideal debt-to-income benchmark. For conventional loans, an ideal front-end ratio is conservatively no more than 28%, and the back-end ratio should be no more than 36%. Lenders’ guidelines differ when it comes to a maximum debt-to-income ratio when deciding to approve a mortgage. The maximum debt-to-income ratio for conventional loans typically falls right around 50%. VA home loans technically do not have a maximum debt-to-income percentage and discretion falls on the lender.
Why is lowering your debt-to-income ratio important before attempting to buy a home?
There are a number of important reasons to make an effort to lower your debt-to-income ratio before applying for a home loan. A low debt-to-income ratio gives buyers more credit bandwidth to afford future mortgage payments. It also frees the borrower of past debt as they move forward into homeownership. A low debt-to-income ratio will make it more likely that you will get approved for a mortgage. It gives lenders a way to measure not just whether a person can take on a mortgage, but what mortgage amount the borrower can reasonably be responsible for. Lenders are concerned with a buyer’s debt-to-income ratio because it allows them to gauge a borrower’s ability to afford future mortgage payments. A low debt-to-income ratio tells lenders that a buyer is not likely to foreclose on the loan in the future.