What is Mortgage Debt to Income Ratio

Calculating your mortgage debt to income ratio is an important step in determining how much a bank or other lender might be willing finance for you to buy a home or other real property.

The debt-to-income ratio is a guideline used by lenders to figure out how much they feel they can safely lend to you without incurring any undue risk of loss.

It is something of a risk-reward calculation a lender makes before authorizing a loan. Banks and other lending institutions want to avoid lending you more money than they think you can back with interest over the life of the loan.

Typical Debt to Income Ratios for Lending

Most banks and lending institutions don't want your monthly housing costs to exceed one-third of your total monthly income, this is known as the front ratio.

The actual percentage allowed may vary somewhat from lender to lender and will be based on company specific mortgage loan guidelines. Counted in your monthly housing costs will be mortgage principle, mortgage interest, property taxes, and home owners insurance.

The monthly principle and interest amount can be obtained from the mortgage loan amortization table. To get the monthly amount for taxes and insurance just divide the annual amount by 12.

Insurance requirements can vary from state to state. In many parts of the U.S. only a fire policy is needed while in coastal or other areas prone to flooding you'll find some form of flood insurance required by most lenders. Other coastal areas may also be subject to special wind insurance policies or premiums where hurricanes are likely to be in issue.

A lender will calculate the monthly cost of each of these items based on your loan terms and determine if you can remain below one-third of your monthly income. If you are able to do so, don’t have lots of other debt, and have cash for a reasonable down payment you will likely get the loan.

Basically things are back to the way they were 10 to 20 years ago in the mortgage industry. The days of no-income verification and no-documentation loans are over.

Now if the lender makes these calculations and you are over one-third of your monthly income you will not get the loan and in reality you really don’t want it anyway because it put a severe strain on your financial situation.

Other Debt Comes Into Play

Here are the basics on other consumer debt. When you add other consumer debt, such as credit card bills, to your monthly housing costs, you get what is called the back ratio.

If you have large amounts of money owed on other bills, this will affect the calculation. The total amount of all your monthly housing costs, plus consumer debts, will not be allowed to exceed the a back ratio percentage cap determined by your lender, usually this cap will be 38% of your monthly income.

The back ratio is seen by lenders as the more important of the two ratios as it tends to give a better reflection of how much you will actually be able to finance and pay back.

The Role of a Down Payment

The mortgage debt to income ratio is not the be all, end all of deciding how much you can borrow—it is simply a guiding factor. Another important factor that can influence how much you can borrow is the cash you are able to produce for a down payment.

Generally speaking, if you can gather up a large down payment the debt to income ratio will play a smaller role in determining how much you can borrow.

Straight Talk About Mortgage Debt to Income Ratio

Every thing described up to this point has talked about the maximum amount you might hope to borrow for a home. In reality, you should think long and hard about taking on this amount of debt. If the last several years have proven anything, it is that those with lots of cash and little debt are far better off today than those who were house rich and cash poor.

In my opinion, you should shoot for a maximum monthly housing expense of about 25% of your monthly income and no more.