Purchasing a home — especially for the first time — can be a confusing and stressful experience, but one thing that can make the process easier is knowing your debt-to-income ratio.
As the Consumer Financial Protection Bureau explains, your debt-to-income ratio is how much you owe (your monthly debt) divided by how much money you earn (your gross income before taxes). While it’s not the only mortgage factor lenders use to assess your application, lenders use this to evaluate your balance between debt and income.
The lower your debt-to-income ratio, the better. That’s because a high debt-to-income ratio means that a lot of your income goes to paying off your debt. This could make you seem like a risky borrower. Lenders use the number to know if you’ll be able to manage the monthly payments needed to repay the money they’re lending you.
AP Photo/John Bazemore, File
Your debt-to-income ratio can be calculated by adding up your monthly debt payments and dividing them by your gross monthly income.
For example, let’s say your annual income is $60,000, which is $5,000 monthly, and your debts add up to $2,000 a month. Dividing $2,000 by $5,000 gives you a debt-to-income ratio of .4, or 40%.
To get a quick sense of what your ratio might be, Wells Fargo offers a free debt-to-income ratio calculator — but you’ll still have to do some outside math to figure out your debt and income before taxes.
What To Include When Calculating Your Debt-To-Income Ratio
When adding up your debt, take a look at your bills. Consider your new mortgage payment’s principle, plus interest, taxes, insurance and homeowners association dues. Also include any other mortgages you may have, alimony and child support payments, credit cards, student loans, car loans, personal loans and any other loans you make a payment on each month.
What’s not included? Household expenses, like utilities, internet or groceries.
To calculate your gross monthly income, you’ll want to consider your income before taxes and other deductions are taken.
If you’re earning income from multiple sources and your income is more difficult to calculate, you can speak with a licensed loan originator who can explain how income stream flows together to create your gross monthly income.
How To Lower Your Debt-To-Income Ratio
According to Bank of America, if your ratio is higher than 36%, you should consider taking steps to reduce it. First, you’ll want to make a plan to pay off your credit cards, then increase the amount you pay monthly toward your debts. If you are able, make extra payments to help lower your overall debt more quickly.
Next, you’ll want to ask creditors to reduce your interest rate. Then, make sure you avoid taking on more debt and seek ways to increase your income. After following the above steps, you’ll want to recalculate your debt-to-income ratio every month to see if it’s improving and discussing the changes with your lender.
You may also find that different lenders have different debt-to-income limits, so if you have trouble getting a loan from one, it wouldn’t hurt to try another.
By Kaitlin Gates, for Scripps News.
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