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Learn about how banks calculate your debt-to-income ratio and how this number affects your ability to get a mortgage.
Many people assume that when they’re getting ready to buy a house, the only thing to consider is whether they make enough to afford the monthly payments. It is at this point that a lot of people first learn about the concept of a debt-to-income ratio. And for some that is not a pleasant surprise.
What is a debt-to-income ratio? Why does it matter?
A debt-to-income ratio is a comparison of the amount of debt you owe against the amount of money that you make. Most commonly, a bank will compare the total amount of money that you must pay toward your debts each month to the amount of money you bring home on a monthly basis. This comparison allows the bank to determine some important things about your budget and your credit worthiness, then make a determination of how likely it is that you will be able to make your mortgage payment every month.
If you’re like many people, you have debt from credit cards, auto loans, student loans, and perhaps even personal loans or medical debt. Each of these loans comes with a minimum amount that has to be paid every month. A mortgage will add to the amount of debt you’re responsible for each month, posing a potential challenge for people who already have several obligations.
Obviously, a high amount of credit card and student loan debt will be a big problem for someone who has a relatively small income. The same debts might not be a big deal for someone who has a very high income. The debt-to-income ratio is a way for banks to easily determine who is paying a large chunk of their income towards the debt they already have. This ratio is computed separately and is not part of a person’s credit score—in fact, income is not taken into account at all when computing a credit score.
There is no absolute formula for what will qualify you for a certain level of mortgage and what will not. A total debt of 40 percent with a mortgage is typical, but this can vary. For example, nearly every lender considers debt-to-income ratios outside of a mortgage above 40 percent to be very risky. Many lenders prefer their mortgage holders to have a debt-to-income ratio outside of a mortgage of 20 percent or less.
At Mascoma Savings Bank, our most important question is, “Can you COMFORTABLY make the monthly payments your mortgage would require?” And it’s usually followed up with, “Will you still have a cushion if you have an unexpected expense, house or otherwise?” In other words, “Would you need to drastically change your lifestyle from what it is now to handle a different monthly payment level, and do you have savings in case you need to repair a leaky roof or incur another large expense?”
If you ever have questions about debt-to-income ratio, consolidating debts, or any other mortgage related questions, I encourage you reach out to me or any Mascoma Savings Bank mortgage lender. We are always happy to answer questions.