To experience the American dream of owning your own home, you must first put yourself in a solid financial position. Many know the importance of having a high credit rating when seeking credit, but lenders often value a respectable debt-to-income ratio over many other factors of credit worthiness. Your debt-to-income ratio provides a snapshot of your current financial situation. Knowing your debt-to-income ratio and improving it could be the ticket to getting the loan you need or securing a lower interest rate. Lenders only care about whether you can pay them back, and borrowers with a low debt-to-income ratio have more income available to repay their loans.
Definition
Your debt, expressed as a percentage of your overall income, is your debt-to-income ratio. Lenders give a lot of weight to this because it shows how much of your monthly income remains after your current liabilities. Since your payment on a potential loan comes from what remains, lenders prefer this debt percentage to be as low as possible.
Front-end Debt to Income
Your front-end ratio is the monthly cost of your home expressed as a percentage of your gross monthly income. This cost includes your mortgage, insurance, interest and taxes. Lenders generally feel comfortable loaning to you if your front-end ratio remains at or below 28 percent. This means you spend 28 percent or less of your gross monthly income on the cost of your home.
Back-end Debt to Income
Your back-end ratio is the monthly cost of all your debts expressed as a percentage of your gross monthly income. This cost includes your home, credit cards, student loans, child support and any other debts. Lenders prefer a back-end debt-to-income ratio below 36 percent. This means that 36 percent or less of your gross monthly income goes to paying debt.
Calculation
To calculate your debt-to-income ratio, gather all your monthly bills. Put aside regular expenses like electricity, phone and cable television. What remain should be your debts. This includes your mortgage, car payments, credit card payments, student loans and other debts. Add the payments for each of these to find your monthly debt amount. Divide your total monthly debts by your monthly income to determine your debt-to-income ratio.
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