Calculate Your Debt to Income Ratio Before Shopping for a Loan
By Sadiya Anjum
Before you go home loan shopping, do some math to calculate the loan amount acceptable to your financial condition and lifestyle. One of the main factors that lenders consider before approving a loan is the debt to income ratio (or debt ratio). A simple calculation can show you how much debt is acceptable in the financial community.
A debt to income ratio is calculated not just for mortgages but for each time you apply for credit. While the acceptable percentage varies for different loans and credits, the acceptable debt ratio for home loans is 36%. A debt to income ratio is represented as two kinds of ratios: front end ratio and back end ratio.
Front end ratio basically represents the percentage of your income that is employed for housing. To calculate this ratio, simply divide your monthly mortgage payments by your gross (before taxes) monthly income. The front end ratio should not exceed 28% (0.28). If you are determining mortgage payments, multiply your income by 0.28 and the result is the maximum limit you can afford.
The back end ratio is your total debt to income ratio. To calculate divide your total debt by your gross monthly income. The result should not exceed 36% (0.36). Your total debt includes: home loan (rental expenses), car loan, student loan, credit cards, etc. but not utilities and insurance. Income should include all sources like child support or alimony, bonuses and commissions etc. but unreported earned income will not be considered. Income from a job is considered as long as it has been uninterrupted work for at least two years.
As long as your debt ratio is within the given limit, chances of obtaining a loan are high. But it should be remembered that ratios are just one aspect of the loan approval process, other factors like stability of income, credit score and history etc. are also considered. Ideally, the lower your debt ratio is the better it is. But even if your debt ratio is up to 50% you may still qualify for a loan provided your credit score and report are impeccable.
However serious thought must be given when obtaining a loan with such a high debt ratio. The big loan you may qualify for may buy you more house but is it really feasible for your financial situation and lifestyle? A considerable sum (above 36%) of your income will represent your debt payments leaving a lesser portion for savings, retirement, other expenses and general entertainment. Dreaming of a big home and pretending that you can “somehow manage later” is an unrealistic and flawed outlook.
Be real with what you can afford and it will allow room for other aspects of your financial life to run smoothly. Besides the lower your debt is the easier you will find it to make payments and in case you lose a job or one source of income, you will still be able to manage your payments. You also need to consider the condition of your credit history which may get damaged by late payments.
To be on the safer side, also calculate the ratios using your net (after deducting taxes) income. This will give you a realistic picture of what you can actually afford as opposed to how much debt you can incur. Using gross income will indicate the maximum amount that you can qualify for but net income will give you a better idea of your financial situation. So calculate your front end and back end ratios using both net income and gross income. With this picture in mind, you will be better prepared to go to a lender.
Article Source: ChoiceOfHomes.com - Home Selling and Home Renting made easy.This article may NOT be reprinted in any form without the express written consent of ChoiceOfHomes.com
©Copyrights ChoiceOfHomes.com 2004-2006