Banking and financial professionals often use terms the everyday person is unfamiliar with. Should your loan application come back declining the loan, one of the likely reasons is debt-to-income ratio. Let’s take a closer look at this topic.
Why Debt-to-Income Ratios Matter
Basically, lenders look at this number of debt-to-income to decide how risky it may be to approve your loan. The lower the debt-to-income ratio is, the less risky you are to lenders. It really does make sense, since if you have too much debt a loan may make it impossible for you to meet all your obligations.
Calculating Your Debt-to-Income Ratio
It is quite simple to calculate your debt-to-income ratio. Add up your month bills including rent, insurance, utilities, debt payments, phone and internet, car payments, and other regularly paid bills. Next, divide the total by the total of your monthly income before taxes. This results in a percentage rate debt-to-income ratio.
What Banks Expect
Lenders are generally looking for a ratio of debt-to-income of under 30%. Anything higher will put you in a questionable range. Others may allow up to 36% or 40% depending on other factors, like savings or how close you are to paying debt off. Generally, a debt-to-income ratio of more than 50% is frowned upon since it leaves you very little wiggle room for other expenses, let along saving or handling unexpected expenses. Many banks still use the 28% rule for income-to-mortgage payment, so they want to see your mortgage at no more than 28% of your income.
Working to Lower Your Ratio
So, you’ve calculated your debt-to-income ratio and your chin dropped to the floor in amazement. Don’t stress too much, there are ways to work on cutting the ratio. Here are a few strategies:
- Look into additional loan programs with more flexibility like an FHA, USDA, or VA loan.
- Consider paying points to get a lower interest rate (and mortgage payment).
- If you have several credit card or small loans, find a way to restructure to a lower interest rate such as special balance transfer offers or work with a bank.
- Use the snowball system to pay off debt. Pay the minimum on all accounts and pay extra when you can to the highest interest account. Then, when an account is paid off, go to the remaining debt with the highest interest and add the previous monthly payment to this second account, and so forth. For example, let’s say you have debts as below:
| Debt Account | Monthly Payment |
Interest Rate % |
# Payments |
| A | $150 | 7.9% | 25 |
| B | $223 | 5.9% | 34 |
| C | $126 | 3.99% | 60 |
| D | $195 | 1.99% | 84 |
At the end of paying off Debt A, for a snowball system, you will add the $150 payment each month following to Debt B (for a total monthly payment of $373). Then, you will pay it off sooner than the 9 months remaining. The payment of $373 is then added to Debt C for a total monthly payment of $499 each month until it is paid off.
We hope this blog clarifies debt-to-income ratio in the complicated world of mortgage loans. If you have any questions or need help understanding how to lower your ratio, CONTACT US TODAY! We’re happy to help you down the road to homeownership.
