Debt Ratio is one of the "Big Three" for Loan Qualification

There are basically three areas of qualification for mortgage loans; the credit history and credit score, the down payment or the equity in the home, and the debt ratio. Debt ratio is a ratio between the Gross Monthly Income and the monthly expenses.

Most Americans are paid a pay check and receive a w-2 each year. Normally that income is easy to calculate. It is simply the larger number before taxes, insurances, etc are taken out from the pay check. There are many rules and guidelines regarding income but for the most part and for most first time home buyers it is simply the gross; not the take home but the amount before taxes.

Expenses: The expenses that are counted in the debt ratio are (1) the complete mortgage expense and (2) all other consumer expenses. The mortgage debt includes the loan payment, real estate property taxes, homeowner insurance, mortgage insurance and HomeOwner Association dues for condo's and townhomes. (2) Most other expenses are picked up from the credit report. Things not counted are utilities, life insurance, child care,  and car insurance. The rules can be strange. Suppose that you have kids in private schools- that is not counted against you. However, child support is a debt (not the same thing as child care).

Now the percentages come into play. It used to be that there were two considerations; a mortgage ratio and then an overall ratio. Today banks only use the overall debt ratio. The trick is to divide the bigger number into the smaller number--that assumes that you earn more than you pay out !  So, gross income is $5600 on a monthly basis and total expenses using the guidelines from above are $1850 then the ratio is 33%. For debt ratio the lower the number the better. Using the same gross of $5600 if the debts are $1500 then the ratio is 27%. Remember, the lower the number the better. If the gross income is $5600 and the debts are $3500 then the ratio is 63% and the loan would not be approved. Most banks will allow for a 45% ratio which means in this example with a gross income of $5600 that the debts could total $2520.

Here is a youtube video that I did which explains debt ratio http://www.youtube.com/watch?v=Syy_y4FMOT4

Doug Jones
Mortgage Magic NMLS 286668