Debt to income ratio is the ratio between your monthly expenses and your income. Before sanctioning a mortgage for your house, the lenders normally calculate the debt to income ratio to work out your eligibility for the mortgage. The ratio is measured against two qualifying numbers 28 and 36. Higher the ratio, lesser is the chance of getting a loan.
The number 28 refers to a maximum percentage of your monthly income the lender allows you for meeting the housing expenses. This includes the loan principal and interest, private mortgage insurance, property tax, and other expenses such as the home association charges.
The number 36 indicates the maximum percentage of your monthly income the lender allows you for meeting both the housing expenses and the recurring expenses such as credit card payments, car loans, education loans, or any other recurring expenses that will not be paid off in the immediate future after taking up a mortgage.
Let us take an example of a borrower whose monthly income is $4000
28% of 4000 = 1120, i.e., $1120 will be allowed for meeting the housing expenses.
36% of 4000 = 1440, i.e., $1440 will be allowed for both housing and recurring expenses together. This means that the person cannot owe other debts more than $320.
Some loans offer greater percentage allowing you for more debt. For example, the FHA loan has a 29/42 scale for calculating the loan eligibility.
Most of the banks insist that your debt-to-income ratio is below 36%. If it crosses 43% you are likely to face financial constrains in the future, and having a 50% or more debt-to-income ratio means that you should immediately work out strategies to reduce your debts before applying for mortgage.
There are some intriguing facts about the debt ratio. Let us consider the facts about a mortgage capacity for a person whose monthly income is $3000 and has no debt. As per a debt ratio 38%, the amount available for the mortgage will be $1140.
On the other hand, suppose you have $4000 monthly income, and you owe a $1000 debt. If you think you still deserve the $1140 for the mortgage (after subtracting the $1000 debt from your monthly income) you are mistaken. The bank does not count simply the numbers; rather it works on the percentage. You will be allowed $1520 (38% of 4000) per month for paying off your debts, including the mortgage. So after deducting the $1000 for other loans, you are left with only $520 for the mortgage!
To conclude, it is advisable to reduce the debts as much as possible. Banks are not bothered about the figures of your income; rather it is concerned about how much you spend from it. Another aspect to consider is the amount you can save for the down payment. If you pay off all your debts and do not save for down payment, you may plunge into a more difficult situation. In this case, you need to consult a mortgage counselor to decide whether saving for the down payment would be ideal than paying off the debts.