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Debt-to-Income Ratio Explained

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If you’re thinking about buying a home in North Carolina, especially your first home, you may have noticed in your research that there are lots of things that a potential lender will look at to determine if they can lend to you and how much. One of the most important numbers to your lender is the debt-to-income ratio. But what exactly is this number and how does it impact your potential mortgage financing? Read on to learn about your debt-to-income ratio and how yours might impact your home purchase.

What is It?
Debt-to-income ratio isn’t just a real estate and finance buzzword—it’s an important metric to determine your financial health. This number compares the debt that you owe with the amount of money you have coming in to provide insight into your ability to pay off debts in the future.

How Do I Calculate My Debt-to-Income Ratio?
Although it might seem complicated, the way to calculate your debt-to-income ratio is fairly simple. Your ratio is your total monthly debt payments (like credit card payments, car payments and other debt) divided by your gross monthly income, that is, your pay before taxes are deducted. For example, if you owe $500 per month in debt payments and bring in $1,500 per month before taxes, your debt-to-income ratio would be .33. Then, multiply that result by 100 to find your debt-to-income percentage. In this case, your debt-to-income would be 33%.

What Does This Number Mean?
Now you know what your debt-to-income ratio is, but what exactly does that mean? A lower debt-to-income ratio indicates better financial health, as it means that a smaller percentage of your income goes toward debt payments. With fewer dollars tied up in your debts, you have more discretionary income, which is a good sign to lenders. A higher ratio might indicate that you have too much debt to handle already, and that you might not be able to pay additional debts. This number helps lenders decide if you can afford to pay back the funds that you borrow. 

What Does This Mean for Home Buyers?
Mortgage lenders aren’t loaning money out of kindness, it is a business transaction for them. That means that they need to ensure they are making a good investment when they provide a mortgage loan. In general, a debt-to-income ratio of 43 percent is the limit for buyers to qualify for a mortgage, although a ratio of less than 35 percent is preferred. Keep in mind, though, that the percentage is for total debt, including your mortgage payment. Your proposed mortgage payment should take up no more than 28 percent of your monthly debt. Even though this ratio might be comfortable for a lender, to achieve long-term financial stability, make sure your debt-to-income ratio is comfortable for you, too.

How Can I Improve my Debt to Income Ratio?
If your debt to income ratio is too high to qualify for a home, the best things you can do are to increase your income or pay down your debts. While preparing to hopefully buy a home, focus on paying off debts, especially unsecured debts, to decrease your monthly debt payments. For example, focus on paying off your credit card debt to free up more of your monthly funding. When you have less debt taking up your monthly budget, your debt-to-income ratio will decrease. As a bonus, paying down debt can also help increase your credit score, another important factor for lenders.

Educating yourself about mortgages, financial health and the home buying process is an important first step in becoming a successful home owner. The NC Housing Finance Agency offers mortgage products that can help make it more affordable. Learn more about all the ways the Agency can help make home ownership a reality for you at www.HousingBuildsNC.com.