What Is Included in the Debt-to-Income Ratio When Doing Home Mortgages?
Many Americans dream of one day owning their own home, but because of the large purchase price, many also are unable to purchase a house with cash. When this happens, we take out a mortgage and we put up the home itself as collateral against the loan. How does a lending institution make the decision to lend us the money to purchase the home in the first place? One criterion that is used is the debt-to-income ratio.
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The Simple Formula
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A bank can use a simple formula or a more complex formula to calculate your debt-to-income ratio. The simple formula involves dividing the total monthly mortgage payment against your gross monthly income. The total payment includes principle, interest, property taxes and homeowner's insurance. For example, if your gross monthly income is $4,200 and your total mortgage payment is $1,300, then your debt-to-income ratio is 31 percent.
The Complex Formula
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A more encompassing formula uses a combination of the sum total of your debts divided by your gross monthly income. In this formula, all debts are included: mortgage, car loans, student loans, credit cards and any other debts. Do not include regular recurring bills such as water, electric and telephone. For this example, you still have a gross monthly income of $4,200, and the total mortgage payment is still $1,300, but you now factor in a car payment of $440, a minimum credit card payment of $125 and a student loan payment of $300 a month. Your debt-to-income ratio in this scenario is 52 percent.
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Gross vs. Net Income
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Since the debt-to-income ratio is based off your gross income, it doesn't always give the most accurate description of your financial situation. It is true that the lending institutions will always use gross income in calculating your debt-to-income ratio; on the other hand, you may want to make the calculation yourself using your net income. Using the previous example and basing your net pay on someone who lives in the state of Florida (Florida has no state income tax, and your specific situation may differ) and is single and only claims one deduction, your gross pay of $4,200 now becomes $3,299 after taxes. Now your debt-to-income ratio is 66 percent ($1,300+$440+$125+$300)/$4,200).
Acceptable Limits
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Before taking on a mortgage, the best debt-to-income ratio you can have is zero. This means that you have no debt and therefore have more income available to make your mortgage payment. If you are debt free then you can safely use the simple debt-to-income ratio calculations, and base it off your net income for a conservative answer. A debt-to-income ratio of 36 percent (if you do have other debts) is at the high end of what many traditional banks like to see, and they don't like to see more than 28 percent of that amount going to service the mortgage.
Conclusion
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Now that you know how to calculate your debt-to-income ratio, you will be much better prepared to make the step toward getting a mortgage and owning a home.
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