Recommended Debt Ratio

Intent and ability are equally important factors in the loan approval process. When reviewing your loan application, lenders look to your credit score to establish intent and to your debt ratio to establish ability. Although your lender uses a standard formula to calculate debt ratio, how it's applied when assessing your ability to repay depends on the type and recommended debt ratio for your loan.

Identification

Debt ratio, also called debt-to-income ratio, compares your gross monthly income, or income before deductions, to your total monthly debt load. Income includes not only wages, but also spousal and/or child support, Social Security or other government assistance, dividends and interest payments and an average for fluctuating income such as tips, bonuses or commissions. Your debt load consists of the minimum amount due each month on credit card and all loan payments, with the exception in some cases of your mortgage payment

Formula

The formula to calculate your debt ratio is debt load/income. First, determine your monthly debt load by adding monthly payments. Then calculate your gross monthly income. If your pay schedule is weekly, multiply your gross weekly wage by 52 and then divide this number by 12, and if your pay schedule is bi-weekly, multiply your gross bi-weekly wage by 26 and divide by 12. For example, if your monthly debt load is $1,200 and gross monthly income is $3500, your debt ratio is 1,200/3,500, or 34 percent.

General Recommendations

Debt ratio recommendations for your loan depend on whether your debt load includes your mortgage payment, in which case recommendations generally allow a higher percentage. According to Bankrate.com, when your debt ratio includes your mortgage, a general recommendation is to keep this percentage at or below 36 percent. When your mortgage payment is not part of the calculation, the general recommendation falls to 20 percent or less, according to MindYourFinances.com

Mortgage Loan Recommendations

Mortgage loans work somewhat differently in that they calculate your debt ratio two different ways. The first, called the front-end ratio, compares your potential mortgage payment, including the principal, interest, taxes and insurance, to your monthly income. The second, called the back-end ratio, compares debt load, including your mortgage payment, to income. An acceptable debt ratio depends on the loan. Fannie Mae and Freddie Mac loans, according to MortgageUnderwriters.com, allow up to 28 percent for the front-end and up to 36 percent for the back-end. FHA loans allow up to 31 percent for the front-end and up to 43 percent for the back-end, while VA loans use only the back-end ratio, allowing up to a 41 percent debt ratio.

Considerations

You can also use this formula to calculate and monitor your debt ratio at home. Keeping track of your debt ratio can help you make smart financial decisions and avoid what MindYourFinances.com refers to as "creeping indebtedness."