Q: What’s In a Ratio?
A: Most likely, whether or not a loan provider will find you creditworthy.
To determine your borrowing power, lenders use guidelines called debt-to-income ratios. These are simply the percentage of your monthly gross income (your income before taxes) that is used to pay some combination of your monthly debts. There are generally three numbers you’ll need to remember when it comes to what these ratios mean in relation to your creditworthiness: 20%, 28%, and 36%.
The first ratio to know is your consumer debt ratio. If this number is more than about 20 percent, your journey toward that new loan, mortgage, or line of credit might just end here, especially if you don’t have a stellar FICO score. (See the 5 other personal financial numbers you should know.)
Banks consider 16-19 percent to be a moderate consumer debt ratio, so if you’re above that range, you might be denied new credit because the amount you currently owe in proportion to your income is too high. Calculate your consumer debt ratio by taking your total monthly consumer debt payments and dividing by your monthly gross income:
To determine your borrowing power, lenders use guidelines called debt-to-income ratios. These are simply the percentage of your monthly gross income (your income before taxes) that is used to pay some combination of your monthly debts. There are generally three numbers you’ll need to remember when it comes to what these ratios mean in relation to your creditworthiness: 20%, 28%, and 36%.
The first ratio to know is your consumer debt ratio. If this number is more than about 20 percent, your journey toward that new loan, mortgage, or line of credit might just end here, especially if you don’t have a stellar FICO score. (See the 5 other personal financial numbers you should know.)
Banks consider 16-19 percent to be a moderate consumer debt ratio, so if you’re above that range, you might be denied new credit because the amount you currently owe in proportion to your income is too high. Calculate your consumer debt ratio by taking your total monthly consumer debt payments and dividing by your monthly gross income:
EXAMPLE: Your loan and other debt payments add up to $1,000 a month, and you make $4,000 in gross income. Your debt ratio is 25% ($1,000 / 4,000 = .25 x 100 = .25%). If this was the case, you should definitely pay down some consumer debt before applying for a new loan, line of credit, or mortgage.
The second ratio that lenders look at is the front-end debt ratio, which is your proposed monthly housing costs divided by your monthly gross income. For the purposes of the ratio, housing costs include not only the principal and interest on your mortgage (or your full rent), but also your property taxes and homeowners (or renters’) insurance premiums, as well as HOA fees. In general, conventional mortgage lenders prefer that a borrower's front-end ratio be 28 percent or less. Replace the consumer debt amount with your current (or estimated/proposed new) housing costs into the top part of the calculation above to get your number.
The third ratio, the back-end debt ratio, puts it all together: the total of all your debt payments divided by your gross monthly income. That includes all your proposed housing costs, plus payments for car loans, credit card minimums, etc. Conventional mortgage lenders generally want to see a back-end debt ratio of 36 percent or less, so if you start with a lot of consumer debt (like more than 20 percent), you’re not likely to get very far unless you’re buying a home that’s relatively inexpensive for you to finance, insure and maintain. (If you made $4,000 per month, as in the example above, meeting this ratio would mean all your housing costs could only total $640 each month—not likely!)
Of the three ratios, mortgage lenders tend to pay more attention to the back-end ratio because it takes into account more of your debt. Sometimes exceptions can be made (up to 40-41%), but don’t count on it! For large purchases like houses, lenders may ask you to pay off consumer debt in order to meet the 36% threshold prior to granting the loan, leaving you needing a lot more cash than you planned for in order to close on your home, so be prepared, and know where you stand before you apply!
See how Brio can help you develop a plan to manage your debt.
The second ratio that lenders look at is the front-end debt ratio, which is your proposed monthly housing costs divided by your monthly gross income. For the purposes of the ratio, housing costs include not only the principal and interest on your mortgage (or your full rent), but also your property taxes and homeowners (or renters’) insurance premiums, as well as HOA fees. In general, conventional mortgage lenders prefer that a borrower's front-end ratio be 28 percent or less. Replace the consumer debt amount with your current (or estimated/proposed new) housing costs into the top part of the calculation above to get your number.
The third ratio, the back-end debt ratio, puts it all together: the total of all your debt payments divided by your gross monthly income. That includes all your proposed housing costs, plus payments for car loans, credit card minimums, etc. Conventional mortgage lenders generally want to see a back-end debt ratio of 36 percent or less, so if you start with a lot of consumer debt (like more than 20 percent), you’re not likely to get very far unless you’re buying a home that’s relatively inexpensive for you to finance, insure and maintain. (If you made $4,000 per month, as in the example above, meeting this ratio would mean all your housing costs could only total $640 each month—not likely!)
Of the three ratios, mortgage lenders tend to pay more attention to the back-end ratio because it takes into account more of your debt. Sometimes exceptions can be made (up to 40-41%), but don’t count on it! For large purchases like houses, lenders may ask you to pay off consumer debt in order to meet the 36% threshold prior to granting the loan, leaving you needing a lot more cash than you planned for in order to close on your home, so be prepared, and know where you stand before you apply!
See how Brio can help you develop a plan to manage your debt.