DEBT RATIOS AND HOW LENDERS CALCULATE THEM
You may have heard the term debt ratio. Debt ratio plays a critical role in how much a lender will loan you. You can shop all you want for interest rates, but what that rate ultimately represents is your monthly payment. And lenders have a formula that helps determine whether you can afford your payments. That formula is the debt ratio.
A debt ratio comes in two types: a housing ratio and a total debt ratio — sometimes called a front and back ratio.
A lender will take your total monthly house payment, including principal, interest, taxes, and HOA fees, and divide that number by your gross monthly income.
For instance, let's say your principal and interest payment is $1,000, taxes are $100, and HOA dues are $75, which adds up to $1,175. Now imagine your gross income each month is $4,000. Divide $1,175 by $4,000 and the answer is 0.294, or 29.4 percent. Your housing, or front, ratio is 29.4.
Now take that same $1,175 and add your car payment of $350 and a student loan payment of $100, and you get $1,625. Dividing that number by $4,000 gives you 0.406, or 40.6 percent. Your total or back debt ratio is 40.6.
Your debt ratios in this example would be 29.4/40.6. What is the maximum debt ratio a lender can allow?
Although there are no maximum limits, the historical standard was around 28/36. But over the years, loan approvals have begun to take a more holistic approach. Today they look at the borrower's overall picture and tend not to decline someone due to just one aspect of the debt ratio.
Again, in this example you wouldn't be declined because your back ratio was 40.6 and not 36. But lenders do start to get a little nervous when ratios exceed 45. If s not a deal killer, especially if there are other factors that compensate for the higher ratio, such as excellent credit or a down payment of 10 percent or more.