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When Brian and I (and I include myself pretty loosely here 😊 ) built our house quite a few years ago, qualifying for a mortgage loan was not all that difficult.
In fact, I’m not even sure that a debt to income ratio was part of the decision making process.
Oh, how times have changed!
My wonderful niece and her husband are in the process of purchasing their first home. She related to me that there is a whole lot involved in applying for and purchasing a home. The lingo is like a foreign language. One of the financial terms to which she was introduced was “debt to income ratio”.
You do not want to hear the term “debt to income ratio” for the first time when you are applying for a mortgage loan.
Debt to income ratio is a term you need to be aware of and monitor way before you start the application process. Many an individual has been surprised to learn that even though they have a good credit score and they unfailingly pay their bills on time they do not qualify for a mortgage loan due to this ratio being too high. (thankfully, my niece and her husband did not have this problem.)
Related reading: Do You Monitor Your Credit Score?
Even if you are not planning to purchase a home this calculation can be used as an indicator of your financial health.
So, what exactly is a “debt to income ratio”?
Allow me to state the obvious before I jump into a basic explanation of what a debt to income ratio is: The lower your overall debt, the better your financial picture is, period.
On the flip side, in the event you decide to purchase a home and you have never utilized credit in any way, you are going to have a tough time convincing the lender that you are a good financial risk. The trick is to show that you can utilize credit responsibly.
A debt to income ratio is a measure, expressed as a percentage, that compares an individual’s monthly debt payments (loans, credit cards, mortgage) to his or her gross income.
Here’s an example: If monthly loan payments together equal 1500.00 and gross monthly salary is $3,333.00 (approximately 40,000.00 per year), debt to income ratio would be 45 percent.
1500.00 / 3333.00 x 100 = 45
Although this is only one piece of the puzzle when qualifying for a mortgage loan, a lower ratio should strengthen your purchasing position.
Typically, a 43% debt to income ratio is about the limit to qualify for a mortgage loan.
Here is an important piece of wisdom to tuck in your hip pocket; don’t allow a ratio to determine what you can afford. Use common sense.
(Better yet, use a zero based budget.)
A debt to income ratio is based on your GROSS pay.
That is what you make before even one penny is deducted from your paycheck. Your net pay, what you actually get to enjoy, is going to be significantly less than your gross pay.
Knowing your debt to income ratio can guide you in making decisions.
Are you ready to apply for a mortgage or is it going to be necessary to tackle a little more of your debt?
Either way, when you visit your lender, you will not be surprised to hear that term for the first time.
Knowledge is power. Use your knowledge of what a debt to income ratio is to make informed decisions.
Disclaimer: I am not a financial professional and I am not trying to give any kind of advice. My goal is simply to give knowledge that can help make informed decisions.
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