Buying a Home – Calculating Your Debt Ratio

An applicant’s debt ratio is one of the primary factors that a mortgage lender looks at when determining whether or not to approve a loan. This is essentially the ratio of the applicant’s personal debt to his net income. Debt ratio is also one of the factors that the applicant can adjust before applying for a mortgage, and as such is something that any potential home buyer should take into consideration.

While different lenders have different precise formulas for determining an applicant’s debt ratio, the general rule is that the lender wants the applicant to have about 30% more net income than his total debt and expenses. Ideally, the applicant wants to have his outstanding debt at between thirty and forty percent of his income. If the applicant has more debt to service than income available, adding a mortgage payment to the mix is not a good idea. The debt ratio is also one of the key determinants to how much a lender is willing to loan and what the monthly mortgage payment should be.

The basic formula for determining an applicant’s debt ratio is to take his net income, divide it by three, and then subtract the amount of outstanding debt. For example, if the applicant has a monthly income of $6,000 and no debt, then $2,000 a month is available for monthly mortgage payments ($6,000 ÷ 3 = $2,000 – $0 debt = $2,000). However, if the same person has outstanding debt of $2,000 then as far as the mortgage lender is concerned there is no money available for a mortgage ($6,000 ÷ 3 = $2,000 – $2,000 debt = $0). At first glance, having a net income of $6,000 a month and $2,000 in outstanding debt does not seem too bad, but a mortgage lender would view this negatively. (Of course, keep in mind that every lender has unique qualifications.)

The debt ratio is not the only factor taken into account when determining an applicant’s ability to make mortgage payments or what those payments should be each month. Making a large equity investment, or down payment, usually has a direct bearing on what one’s monthly payments will be. The same is true if the borrower has significant semi-liquid assets besides his regular monthly income, such as a large stock portfolio or retirement plan. These and other factors can offset a less than ideal debt ratio. Nevertheless, the applicant’s debt ratio is one of the key factors that most mortgage lenders will look at.

The key advantage relating to the importance of the debt ratio to the prospective home buyer is that this is a determinant that can be adjusted before applying for a mortgage. By paying off debt before applying for a mortgage, the potential borrower can significantly improve his chances of getting approved at reasonable terms.