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Evaluating Your Debt Ratio It's exactly what you have been looking for. A combination DVD, big screen TV and surround sound stereo home entertainment system. You really want it. The features are great, the style is the latest, and it's affordable. After the down payment the monthly cost is only $90 a month. "Would you buy this system today, if I can include an extra set of woofers and free installation?" asks the salesman. Before emitting a strong "yes" stop and consider what's about to happen. Before you increase your debt and monthly payments, you should consider your debt ratio. Lenders don't like risk. A lender's view of financial perfection means making loans to borrowers who always pay their debts. Some borrowers don't re-pay, so lenders need to limit their risk. They do this by checking the borrowers debt ratio and assuring that they are well-qualified. The expression "well qualified" as lenders use the term means something more than finding borrowers with good incomes. Yes, lenders want sufficient income for any level of borrowing, but they also want something more, a sense that borrowers are not burdened with too many bills. To lenders, this means limiting debt and monthly costs. Lenders typically qualify borrowers on the basis of two measures: front ratios and back ratios. In general terms, these standards work like this: The "front ratio" is the percent of your gross monthly income used for mortgage principal, mortgage interest, property taxes, and property insurance. Depending on the loan program, lenders might allow 28 to 41 percent of a borrower's income for "PITI." The "back ratio" includes PITI plus car payments, student loan payments, credit card payments, auto loan payments, etc. Back ratios typically range from 36 to 41 percent, but can be greater. Let's say you want to buy a house at $150,000 at 7 percent over 30 years. The monthly cost for principal and interest is $997.95. Let's also say that the monthly cost for taxes and insurance is $250. The total for PITI is $1,247.95. If a lender will only allow 28 percent of your income for PITI, it means you must earn at least $4,457 before taxes each month. If the lender allows 36 percent of your income for the back ratio, then if you earn $4,457 month as much as $1,605 is available for housing costs and other monthly debt. Since $1,247 is already committed to PITI, $358 remains for installment loans, credit card debt, and such. ($1,605 less $1,247 = $358). You
see the problem. That high tech, fancy home entertainment system
will increase your monthly debt load to the point where you may
not qualify for a $150,000 mortgage or a new car later on down the
road.
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