Your debt-to-income ratio can tell you how much you can borrow
Mortgage lenders use debt-to-income ratios to gauge how much you can borrow safely. You can use them too, to figure out how much house you can afford.
This page:
• Introduces debt-to-income ratios
• Explains how to calculate debt-to-income ratios
This section is part of our mortgage planning guide. In case you missed it, it lays the groundwork for an easy home loan process and covers important topics about fixing your credit, timing mortgage interest rates and managing your investment.
Your debt-to-income ratio is the best measure of how big a mortgage you can afford
Debt-to-income ratios are often the simplest across-the-board method for figuring how much house you can afford. Your lender uses a similar calculation when reviewing your loan application and the ratios can also be very useful to you before you start looking for a home (or while deciding if you can truly afford one you've found.)
Most Americans spend about a third of their incomes on housing costs, and lenders are wary if you apply for a mortgage that would cause your ratio to be a lot higher.
Of course, lenders also consider your current housing expenditures when deciding a healthy monthly mortgage payment size. So if you are looking to buy in an expensive area, like New York City, and have been managing a high rent-to-income ratio for a while, your lender may be more flexible about the ratio.
Getting an accurate picture of your debt load
This one third figure for debt-to-income is just a loose estimate. For a more accurate picture of your borrowing capabilities, you need to look at your front-end and back-end ratios (also called debt-to-income ratios, which gets confusing.)
This part involves some calculations, so get ready to do a little math.
The front-end ratio measures how much of your gross (pre-tax) income goes toward your mortgage payments. (These payments include interest, principal, taxes, and maybe insurance.) A general rule of thumb is that the front-end ratio should not exceed 28%. Of course, right now you may not know what size monthly payments you'll be facing. That's okay. By multiplying your gross income by 28%, you'll get a good payment "ceiling" to use when you do apply.
The back-end ratio is similar, only it is a comparison of gross income to total monthly debt obligations (this includes loans, mortgages, credit card payments, child support, alimony, condominium association fees, etc). This ratio generally should not exceed 36%. So if you have a lot of additional debt, you may have to scale back the amount you plan to spend on housing.
Besides these very important debt-to-income ratios, there's one more related figure you'll run into during the mortgage process. This is the LTV, or loan-to-value ratio. It's simply an expression of the size of your loan to the cost of your home.
The LTV is a good figure to keep in mind as you decide on a reasonable size for your mortgage, as a mortgage with an LTV over 80% will often involve a higher interest rate and increased mortgage insurance costs. By making a down payment of 20% or more, you can avoid a lot of this additional expense.
In conclusion...
These debt-to-income and loan-to-value rules aren't hard and fast. For example, if your income or down payment is extremely high or you live in a very high cost-of-living area or you have a lot of valuable assets, lenders may be more flexible. And you might be more confident in your ability to handle a lot of debt or a large loan, too.
But in general, it's not a bad idea to hold yourself to these standards, even if your lender is more relaxed. Financial over extension can be very stressful and burdensome. It's really a question of honestly assessing how much you value a bigger, or better home.
Next: Home buying the easy way: with a pre-approval and rate lock
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