The Debt Ratio

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The bank wants to be sure you can afford to pay them back before they give you a loan. One way they consider your ability to repay is by making sure your total debt doesn't exceed a certain percentage of your income, usually 36-42%. This percentage is called the debt ratio.

Let's say you make $3000 a month and have no debt. The bank would figure that you weren't overextended as long as your mortgage payments, including taxes and insurance, wouldn't exceed $1080 to $1260. On the right we can see this in pie chart form, using a debt ratio of 38%. The pink area is the amount available for our mortgage payment ($1140).

Now let's look at a case in which you have some debt, since most people do. We just looked at the case of having $3000 in monthly income and no debt. But what if you have $4000 in monthly income and $1000 in monthly debt? You'd think that the amount you could borrow would be the same, since you still have $3000/mo. available. But unfortunately it doesn't work out that way.

Remember that the bank wants you to have no more than about 38% of your income as debt. So if you have $4000/mo. in income, then $1520/mo. of this is available for total debt. ($4000 x 38%). Of that $1520/mo. you already have $1000/mo. in debt, leaving only $520/mo. for mortgage payments. Ouch.

Let's look at that again because it's important:

  • $3000/mo. income and no debt: Your mortgage payments can be as high as $1140/mo.
  • $4000/mo. income and $1000/mo. debt: Your mortgage payments can be only $520/mo.

Is this fair? Not really, but there's nothing you can do about the way the banks operate. What you can do is to reduce your debt as much as possible. Of course, the more you pay down your debt, the less you have available for a down payment. So should you or shouldn't you? Let's consider that question....

"Should I use my cash to pay down my debt, or save the cash for my down payment?"

      This isn't always an easy question to answer, since the answer depends on lots of variables. But we'll try to provide some general guidelines. It will be helpful to calculate your debt ratio first, though.

$

Monthly Income (before taxes)

$

Monthly Debt (minimum payments on credit cards, auto loans, school loans)

Your Debt Ratio

  • If your debt ratio is more than 38% you have no choice. No bank will give you a loan when your debt ratio is already this high. You must pay down your debt first.

  • If your current debt ratio is more than about 20%, you have little choice: With a debt ratio this high your borrowing power is severely limited. Pay down your debt to below a 20% debt ratio. Banks consider 16-19% to be a moderate debt ratio.

  • If your debt ratio is less than 20% and paying down your debt would mean that you can't make a 20% down payment, keep the cash and make the 20% down payment. Putting 20% down can get you a better interest rate, make it easier to qualify for the loan, makes for a smaller mortgage payment, and means you don't have to pay for Private Mortgage Insurance.

  • If you're not going to be buying for at least a few months, and some of your debt is high-interest (more than 10% interest, like credit cards), and paying down your debt won't keep you from putting 20% down on the house, then pay down at least some of your high interest debt. Pay at least 2-3 times the minimum payment each month, or more.

  • Don't worry about paying down your debt if your debt ratio is 6% or less. Banks don't just limit your monthly payment with the debt ratio, they also limit it with the housing ratio, which is a percentage of your income regardless of how much debt you have. When you have a lot of debt the debt ratio is the limiting factor in how much you can borrow, but when you have little to no debt, the limiting factor is the housing ratio. If your debt ratio is 6% or less then paying down your debt probably won't let you get a bigger loan, so don't worry about paying it down.

  • If you don't fall into any of the above categories, then it probably doesn't make a lot of difference what you do. One choice will be better than the other to be sure, but the difference probably won't be that great, and it will take some doing to figure out. At that point I wouldn't worry about it, but if you're determined to find an answer then try using a mortgage calculator (E-Loan, Yahoo, or Octopic.) or talk to a loan officer at a bank.

 

Getting the largest payment possible

     Earlier we said that banks want your total debt payments to be within 36 to 42% of your income. So how do you get towards the higher end of that range? The answer is that banks will allow a higher debt ratio when you put more money down on the house, and when your credit is good. The higher the down payment and the credit score, the higher the debt ratio the bank will allow. You can figure on 36-40% for less than 20% down, and 36-42% for 20% or more down. It's still a wide range because what the bank allows also depends on your credit score.




» Related:  Qualifying for a loan  •  How much home can you afford?

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