My oldest son was asking my wife and I the other day, “When you’re buying a house, how can you tell how much you can afford?” He will be graduating college next year and has the wheels already turning on how to get his own place and be more independent. The quick answer from us was simple, “You just go to the bank and tell them how much you make a month and how much your bills are each month, and they tell you your pre-approved amount.” We also told him that they will give you an idea of what the payment is a month, then you determine for yourself what you believe you’re comfortable paying. Then find a house in that ballpark.
That was a long-winded, detailed answer, on how to determine what you can afford. One way we could have answered was by saying, “You determine your debt-to-income ratio.”
What Is The Debt-to-Income Ratio?
The debt-to-income ratio is a ratio used by banks to determine what you qualify to borrow for a loan. It is calculated by adding up all your monthly expenses and then dividing them by your gross monthly income. Your monthly expenses considered include any current loans and debts you have, not things like food, entertainment costs, or costs for services like Netflix and Hulu. Your gross monthly income is all the money you make in a month before any taxes or deductions are taken out. Dividing your monthly expenses by your gross monthly income will provide the banks with a ratio that will give them an idea of what you can afford to pay each month.
A Simple Example And the 43% Ratio
Let’s say that you currently pay $1500 a month for a mortgage, $500 in car loans, and $200 in student loans, with a gross money income of $7000, your debt-to-income ratio would be 31%. Okay, so how does a bank use that? That’s where the 43% debt-to-income ratio becomes important. 43% is the highest percentage possible to receive a qualified mortgage. If your debt-to-income ratio is north of 43%, chances are you will NOT get the loan.
Your debt-to-income ratio is a key ratio used to determine your eligibility for a qualified mortgage and other loans you’re seeking. Simply put, the ratio’s goal is to determine what you can afford to pay each month on a loan. By adding up your monthly debts (not including entertainment, food, and miscellaneous services) and dividing it by your gross monthly income, the debt-to-income ratio is determined to help you qualify for a loan.
The short answer, and best position to be in, is to have as much income as possible and as little debt as possible. This will keep your debt-to-income ratio low and make you eligible for any loan you need with the best interest rate possible. Using this simple ratio, you can determine you’re eligibility for a loan before you even talk to a bank. Increase your chances of approval by getting rid of those debts and increasing your income!!!