Debt to Income Ratio: More Important Than Your Credit Score?

Understanding Your Debt To Income Ratio is simple once you understand the what is being measured.

Your debt to income ratio is exactly what it sounds like.  It compares the amount of debt you have to your income.  This is actually very important number, maybe even as important as your credit score.

A good rule of thumb is to keep your debt to income ratio below 36 percent.  FHA.com states that the Federal Housing Administration (FHA) has guidelines in place to prevent homebuyers from buying a house that they cannot afford.

The FHA, as well as other mortgage underwriters, will look at two ratios.  For both calculations, the FHA considers the total amount of the new house payment to include principal and interest, escrow deposits for taxes, hazard insurance, mortgage insurance premium, and homeowners’ dues.  Effective income is simply the borrower’s (and spouse’s) gross monthly income.

Ratio #1

The first ratio is called mortgage payment expense to effective income. It looks at how much of your income will be dedicated to housing.  Divide the total amount of the new house payment by effective income.  To qualify for an FHA mortgage, this ratio must be 31% or less.

According the Census Bureau, the median U.S. income was $50,054 in 2011. Using this figure, $1,293 per month would be the maximum house payment under FHA guidelines.

Ratio #2

The second ratio is total fixed payment to effective income.  This ratio looks at how much of your income will be dedicated to debt and housing together.  First add your monthly debt payment to the total amount of the new house payment.  Divide the result by effective income.  The FHA set the maximum ratio at 43%.

Using the U.S. median income again, the maximum of all debt and housing payments is $1,793.  This means that if you want to qualify for the maximum loan that you are eligible for according to income, your total other debt payments cannot exceed $500.

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Of course, the FHA and other lenders will also consider other factors such as credit history and job stability.

While a good debt to income ratio cannot guarantee that you will get the loan you want, it can disqualify you.  Therefore, monitoring your debt to income ratio is as important as monitoring your credit.