If you have recently applied for any type of loan, especially a mortgage, then you may have heard the term “Debt-to-income ratio” bandied about by your loan officer.
Your debt-to-income ratio is the sum of all your monthly debt payments divided by your gross monthly income. This number gives lenders a way to measure your ability to repay your loan, based on your income.
"If the amount of income being devoted to paying off debt gets too high, it’s likely you will either default or starve."
Basically, imagine that your monthly mortgage is $1,000 per month. If you also have a car payment of $300, a student loan payment of $350, and a credit card payment of $150, your total monthly payments are ($1,000 + $300 + $350 + $150) = $1,800. If you have a gross monthly income of $4,800 (gross means before taxes and adjustments, people), your debt-to-income ratio is ($1,800 / $4,,800) = 37.5%.
This means that 37.5% of your gross monthly income is devoted to servicing your debt. Lenders know that beyond this, you still have to afford to eat, insure your belongings, and buy cat food. These “other than debt” costs are actually why lenders pay attention to this ratio. If the amount of income being devoted to paying off debt gets too high, it’s likely you will either default or starve. Generally, defaulting is what more people opt for.
Your debt-to-income ratio will likely be evaluated before any [reputable] lender makes any kind of loan to you, but this ratio is especially important for a home loan. In order for a new mortgage to be considered a “Qualified Mortgage”, the borrower must have a debt-to-income ratio of less than 43%, including the new payment.
Oh, and in case you were wondering, a Qualified Mortgage is one that meets certain standards, ensuring that the lender did their due diligence to make sure you can afford the loan, and which gives the lender access to certain legal protections.
There may be circumstances where you could get a mortgage while having a debt-to-income ratio of more than 43%, but that loan may not be in your best interest. Before taking out any new loan, carefully consider for yourself if you can really afford the payment, and afford a comfortable, financially-savvy lifestyle.
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