Wednesday, October 10, 2012

How to Calculate Your Debt to Income Ratio

Debt. At one time it was a dirty word. In fact, for much of American history, it wasn't that easy to get into debt. Real estate mortgages, car loans, and student loans weren't invented. If you wanted something, you paid cash. In recent decades this has all changed. Remember when you were greeted by friendly people on your college campus who offered you all those fun credit cards? Or how about the first time you bought a car because you qualified for "first time buyer" interest rates? At the time, these things seemed so manageable but now that you are looking to buy a house, you might find your debt-to-income ratio is higher than lenders would like.

One of the first mistakes first-time home buyers make is thinking, "We can pay the rent - and our mortgage is going to be even less than that - so of course they'll approve our loan! Right?!?" Hm. You might be wrong. Unfortunately, real estate lenders don't pay much attention to whether or not you have paid your rent on time for 15 years. They are much more concerned with two factors: your credit score/history and your debt versus income ratio. If either or both of these is undesirable you will either be denied, forced to find a co-signer, and/or offered an insanely high interest rate. So what exactly is a debt-to-income ratio? And how can you fix yours if it isn't so hot?

Calculating your Debt versus Income Ratio

At the end of the day, debt versus income ratio is a basic math equation; you add up every debt payment you make each month and divide that by your total average monthly income. You will end up with a percentage. In the world of Credit Scores 700 is a magic number. Based on this number a person's credit score falls into "Strong" "Decent" "Weak" and "No Way" categories. debt-to-income ratios are judged by percentages. In general, 36% is the magic number. Most lenders want to see that your debt payments each month are 36% or less of your gross monthly income.

If you take the amount of your gross income every month, and multiply it by .36, the number you get is the maximum number of dollars a bank/lender wants to see. Another way to figure out your debt-to-income ratio is to use this debt versus income ratio calculator. If you see a number that's higher than you like, it's time to start eliminating some debt.

Where to start? Increase your income and lower your expenses. For many, increasing income isn't an option. If you want to qualify for a real estate loan, you must create a realistic budget, cut expenses, and put those savings into debt reduction. Just one year of diligent effort on your part can significantly alter that debt-to-income ratio, which can help you qualify for the home of your dreams. So get your debt-to-income ratio where it should be and start shopping for real estate.

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