Spend Much? How Lenders Use Your Debt-to-Income Ratio
Once you understand what you’ll be paying for, and that you’ll probably need a mortgage to make it happen, the obvious question is, how much can you borrow? To know that, you need to understand how lenders think. Just as you’re trying to get the best loan, lenders are looking for the best borrowers.
Without knowing you personally, lenders need some criteria to figure out how risky it is to lend you money. If you make your payments, they’ll turn a profit, either in interest or by selling your loan on the secondary market. If you don’t, they’ll have to chase you down for the cash or sell the property to try to get it.
One of the criteria that lenders use is the comparison between your income and your debt load, called your “debt-to-income” ratio. They also look at your track record for paying previous debts, or your credit history, discussed below.
If You Get a Loan for $250,000 …
Assuming you’re an average buyer (with about $450 per month in debt obligations) and you buy an average house (with average property taxes and insurance costs), here’s about what you can expect to pay on a $250,000 loan:
The concept of “debt-to-income ratio” isn’t as complicated as it sounds. The lender simply looks at your household’s gross monthly income, then makes sure that your combined minimum debt payments—for your PITI (including any community association fees), credit card, car, student loan, and others—don’t eat up more than a certain percentage of that amount. The idea is to make sure you have enough cash left over for your mortgage payment.
Maximum Acceptable Ratios: The 28/36 Rule
How high can your debt-to-income ratio go? Traditionally, lenders have said that your PITI payment shouldn’t exceed 28% of your gross monthly income, and your overall debt shouldn’t exceed 36%. (Your gross monthly income means the amount you earn before taxes and other monthly withdrawals, plus income from all other sources, like royalties, alimony, or investments.)
EXAMPLE: Fernando and Luz have a gross annual income of $90,000 ($7,500 per month) and a moderate amount of existing debt. If they plan to spend 28% of their gross monthly income on PITI, they’ll pay $2,100 each month. Assuming they spend about $300 of that on taxes and insurance, they can borrow about $285,000 using a 30-year, fixed rate loan at 6.5% interest.
Khanh and May also have an gross annual income of $90,000, but they’re debt-free, so they can spend 36% of their gross monthly income on PITI. Spending the same on taxes and insurance, they can borrow about $330,000 using a 30-year, fixed rate loan at 6.5% interest. With the same income but a higher debt-to-income ratio, Khanh and May can spend a lot more money on a house than Fernando and Luz.