If you’re trying to buy a house, you might have come across the term, “debt-to-income ratio.” The term can be confusing, especially if you’re a first-time home buyer.
In this post, you’ll learn about the debt-to-income ratio and how you can calculate yours, so you can get a loan to purchase a house.
If you want to know how to figure out your debt-to-income ratio to get approved for a home, keep reading.
What Is a Debt-to-Income Ratio?
Your debt-to-income ratio is a quick way for lenders to know how much debt you have compared to your income, and the likelihood of whether you’ll be able to afford the loan payments.
The ratio is based on how much of your gross income goes to:
- Future housing expenses, aka the front-end ratio. Future housing costs include the monthly mortgage payment, homeowner’s insurance, property taxes and any homeowner’s association dues.
- Current debt, aka the back-end ratio. Current debt includes monthly credit card, student loan and car payments, plus child support and any other debt.
How to Calculate Your Debt-to-Income Ratio
To calculate your front-end ratio, add up your monthly housing expenses and divide them by your gross monthly income.
Then, calculate your back-end ratio by adding up your current monthly debt payments, and dividing them by your gross monthly income.
Gross monthly income is the amount you make per month before taxes.
What Is a Good Debt-to-Income Ratio?
As a rule, a good debt-to-income for the front-end ratio (housing costs) should be less than 28%. The back-end ratio (current debt) should be 36% or lower.
That said, many lenders will make exceptions. They could even accept an overall debt-to-income ratio as high as 50%, especially if your credit score is good, if you have savings in the bank and if you have adequate money for a down payment.
How to Improve Your Debt-to-Income Ratio
If your debt-to-income ratio seems too high, you may want to try lowering it before you apply. Here are some ways:
- Increase your income: Boost your pay by increasing your business income, getting a side hustle or asking for a raise at work. Raising your pay will change the income portion of the calculation and force the ratio lower.
- Pay down your debts: Use money earned from extra income to lower debt. Besides raising your monthly salary, you could sell some of your stuff or rent out your property to pay down debt.
- Lower your interest rates: You can also try lowering your monthly debt payment by refinancing loans and taking advantage of 0% balance transfer offers. This will make it easier to completely pay off the debt too.
Knowing your income-to-debt ratio is a crucial step to getting approved on a mortgage. You can calculate your front-end ratio by adding your monthly housing costs and dividing by your monthly gross income. Then calculate your back-end ratio by adding your monthly debt payments and dividing by your monthly gross income. Want more guidance on credit and financing a home purchase? Schedule a Free Consultation and we’ll be happy to help you reach your goals.