Wednesday, January 19, 2005

Your Debt Ratio

What is your debt to income ratio?

Every time you apply for a credit or a loan, the lender must determine your debt to income ratio. This measures what percentage of your gross monthly income (everything before taxes are deducted) that goes towards paying off your debts. The debt to income ratio formula varies slightly according to the type of creditor or lending institution that you're dealing with. Your credit card company for example might accept a higher ratio as long as you make all of your payments on time.

Mortgages on the other hand are large, long term debts. In this case, most lenders will want to make sure that you are at the lower end of their debt to income ratio threshold. So, how does one go about calculating this important number? The easiest way is to divide the total of your monthly payments by your gross monthly income. For example, if your total debt payments are $500 with a $2000 per month paycheck, your debt to income ratio is 500/2000 = .25 or 25%.

So what does that number mean?

In general, the lower your debt to income ratio, the better. It shows that you have fewer obligations and are more likely to keep up all of your existing payments. A generally recommended ratio is 15%. All of your car loans, credit card payments, student loans and more should stay at 15% or less. Mortgage companies are looking for customers whose housing costs will probably be around 30% of their household income. This does not mean that you will be turned down for a home loan if you are at 40% or even 50%.

Clean credit beats DIR?

If you are very young and upwardly mobile, or live in New York City for example, it is possible that your debt to income ratio will always be above the recommended threshold. Most mortgage financing institutions will work with you to provide an appropriate loan product or an interest rate that will qualify you for a home loan. The cleaner your credit, they more flexible mortgage lenders will be when considering your entire financial profile. A large debt load with a consistent payment history can be better than a small debt to income ratio with an imperfect or poor credit history.

Do your homework and keep an eye on spending habits. In addition, use a good online mortgage calculator to ensure that you won't trade your future home ownership dreams for impulse purchases and credit card debt.