Your debt to income ratio is one your most important financial statistics. If you've ever bought a home you'll remember that was one of the pieces of financial information your lender wanted. If they were concerned about getting you the best mortgage, they showed you how you could improve it.
Just how do you calculate debt to income ratios anyway? For that matter, after you calculated it, what is an acceptable debt to income ratio? Calculating your debt to income ratio is fairly simple, You merely divide your monthly gross income by your outstanding debt. To calculate the ratio, you have to take your annual gross income and divide by twelve. I know, you were told there would be no math, but it's pretty darn simple, really. This calculation gives you your average monthly gross income. Here's where you wish you'd claimed all those tips and side jobs you've been gloating about. If you haven't reported them, you'll have a harder time getting your lender to believe you really have that level of income.
After you figure out your average monthly income, you'll need to look at two different percentages. If you are going to get a conventional mortgage, you'll use 28% and 36%. If you are getting an FHA or VA mortgage, you'll use slightly higher percentages; 29% and 41%. What do those percentages mean? The first is the percentage of your gross income you can use for housing expenses. That will include your house payment, all your housing associated insurance, and interest. These expenses are abbreviated PITI, for Principle, Interest, Taxes, and Insurance.
If, for example, your W-2 income was $55,291 last year, you'd divide that by 12. The result of that calculation is your average monthly income: $4,607.58. Depending upon the type of mortgage you'll be getting, that will give you the amount of house payment you can be approved for, all else being equal. In this example, you'd be able to afford a house payment of $4,607.58 x .28 for a conforming mortgage. $4,607.58 x .28 = $1,290.12. As you can see, that's not too much house in many metro areas. For example that house payment will allow you to technically afford, at this week's average 30 year fixed mortgage rate of 5.52%, a mortgage with a balance after your down payment of $227,000. You might want to avoid the mistake made by too many people leading up to our recent credit problems, and finance less than that.
Wait a minute, what about that second percentage? What does it mean? That 36% or 41% is the amount of house you can afford according to the standard debt to income calculation, after you include all your other recurring debt. This is where you include your credit card bills, car payments and store charge card payments. This is why your loan officer is telling you to pay down some of this type of debt. You can qualify for a larger mortgage if your recurring debt is lower.
Let's look at the above example, but assume you have only one car, a 2005 Honda Accord LX. That's a nice, sensible, family sedan with a price when it was new of about $22,000, depending upon the option level. Say out the door, with taxes an license, you're into it for $24,000. If you financed this car when it was new, and got 4.9% financing, your monthly payments would be about $450 per month. Let's also assume that you have the national average credit card debt of about $8,500, depending on whose statistics you look at. If you are also paying the national average gold card interest rate of 11.73%, your monthly minimum credit card payment amounts to somewhere around $260. (You can take heart in knowing that if you make only the minimum monthly payment on your cards that it will take only about 15 years to pay off the $8,500 and you'll pay about $4,000 in interest on the $8,500 principle amount!).
If you include your car payment of $450, and your credit card payment of $260, your recurring monthly expenses are $710. $710 added to $1,290.12 gives you a nice, round $2,000. Your mortgage lender will let you have 36% of your monthly gross income be consumed by PITI and recurring monthly expenses. Your current gross monthly income in this example is $4,607.58. 36% of your monthly gross is only $1,658. In this example, you're way too high after adding in your monthly expenses, to qualify for your house. Now you see why you see so many used car ads that read “Must sell, buying house”. With this level of monthly recurring expenses, you can only qualify for a house that's $948/ month. You'll be staying above the garage.
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