The Debt Ratio

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.  This percentage is called the debt ratio.  If your debt ratio is too high, no loan for you.  In the most generous case a bank will let you have a debt ratio of 42%, but they might require a lower ratio for your particular case.  The pie chart at the right shows it in graphical form, if your bank limits your debt ratio to 38%.

To calculate the debt ratio, just divide your debt by your income.  For example, $1000 in monthly debt divided by $3000 in monthly income is a debt ratio of 33.3%.  Your debt includes existing minimum payments on credit card and loan payments, as well as the mortgage payment you'd have if you get the loan, including taxes, insurance, and any mortgage insurance premium.

Let's say that you make $3500/mo., and your bank allows a debt ratio up to 38%.  That means your monthly debt can be as high as $3500 x 38% = $1330.  If you're currently debt-free, then $1330/mo. is enough to buy a modest house.  But if you already have some debt, there's not much room left for a mortgage payment, is there?

Let's run some examples so you can see how having debt holds you back.  In the first example you make $3500 a month and have no existing debt.  Your mortgage payment would be $1300/mo., so your debt ratio would be $1300 $3500 = 37.1%, so if you bank allows a debt ratio of no more than 38% then you just squeaked in.

Now let's look at a case in which you have some debt, since most people do.  In this example 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 for your mortgage after your existing debt obligations.  But unfortunately it doesn't work out that way.  Our total debt would be the $1000 existing + $1300 for the mortgage, or $2300.  That makes your debt ratio $2300 $4000 = 57.5%.  No way will you get a loan with a debt ratio that high.

Let's look at that again because it's important.  With a bank limit of 38% for the debt ratio:

  • $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.

In both cases you have $3000 in free income after meeting your existing debts, but in one case you can borrow only half as much as the other.  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,
   plus your anticipated mortgage payment,
   including taxes, insurance, and any mortgage insurance premium)

Your Debt Ratio

  • If your debt ratio is more than 42% 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.  (Most banks had a hard upper limit of 42%, and as of 2014 it became enshrined in law.)

  • 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 limit your monthly payment with the debt ratio alone, they limit it also 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 might be a little better than the other, 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 want to pursue it then your loan officer can advise you.

 

Getting the largest payment possible

     As we saw, the upper limit for the debt ratio is 36 to 42%, depending on how generous the bank is.  So how do you get towards the higher end of that range?  You can often get 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?

If you liked this site then you might like some of my other sites:

How to Find Cheap Airfare     How to Save Electricity     Slot machines demystified

Entire site ©1999-2023 Michael Bluejay Inc. • All information is "use at your own risk"   Contact


Last update:  October 2013