The debt-to-income ratio is a way for lenders to assess how likely you are to be able to afford the payments associated with any debt you borrow. To calculate your debt-to-income ratio, you add up all your monthly debt payments and divide them by your gross monthly income. According to the CFPB, evidence from studies of mortgage loans suggests that borrowers with a higher debt-to-income ratio are more likely to run into trouble making monthly payments. The 43% percent debt-to-income ratio is a significant cut-off level for many types of mortgages, but you can still find mortgages that allow for debt-to-income ratios as high as 50-55%.
Your gross monthly income is your annual income before taxes divided by 12. You can think of this as the income that shows up on your annual W-2, divided by 12, or the income that shows up on your 1099’s,divided by 12; or if you get paid 2x a month, add up both of those paystubs before taxes are deducted.
Example: If your annual W-2 income is $120,000, then your monthly income is $10,000.
If you rent, this is the amount of your rent payment each month. If you own a home, this is the sum of all your associated monthly payments (principal, interest, taxes, insurance, and HOA).
Example: You have a $400,000 home with a $300,000 mortgage; the total of all your monthly housing payments is $1,900.
If you use credit cards, this is the minimum monthly payment required by the lender.
Example: You have a $5,000 balance on your credit card; the minimum monthly payment might be $100.
This is the monthly payment foryour car, which could be associated with a lease or a loan. If your loan or lease will be up within 10 months, and the total remaining payments is <5% of your gross monthly income, then you can exclude this from your debt calculation. This rule applies to other closed-end loans as well (typically student loans or consumer installment loans; not credit cards,which are open-end).
Example: You have 12 months left on your car lease, and the monthly payment is $400 per month.
If you have a student loan, the monthly payment needs to be included in your total debt payments.
Example: You pay $300 per month on your college loan.
An installment loan is a type of loan you repay over time with regularly scheduled payments.
Example: You have a $5,000 personal installment loan with a monthly payment of $130 per month.
Example: You're married with no prior marriage or children. Your other payments are $0.
Using the examples above, your total monthly debt payments would be ($1,900 + $100 + $400 + $300 + $130) =$2,830.
Your gross monthly income is $10,000.
Therefore, your debt-to-income ratio is 28.3%.
To ensure that the buyer (and lender) is paying a fair amount for the home, buyers insert an appraisal contingency, which allows the buyer the ability to walk away from the purchase without penalty if the appraisal returns a value lower than a set value (usually the purchase price). Aside from walking away, the buyer can renegotiate for a lower price with the seller, request that their lender make an exception, and approve their loan as if the property had appraised to match the purchase price or make up the difference between the purchase price and appraised value via their own funds. In most cases, if the buyer makes use of the appraisal contingency to walk away, they are likely to receive a complete refund of their earnest money. However, buyers must be cautious and include this in the contract to avoid problems at a later stage.
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Serious about buying a home? Realtors prefer showing homes to buyers with a pre-approval letter. Learn the difference between pre-qualification and pre-approval, the benefits of a pre-approval letter, and why you need one.
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