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This is the ratio between how much you owe each month on personal debt and how much you earn. This ratio calculates the percentage of debt you are carrying in relation to how much money you are making and gives lenders a good indication of how much additional debt you’ll be able to handle.
The arithmetic
In order to make the calculation, add up your fixed monthly expenses such as your car payments, minimum credit card payments and any other regular debt obligations such as monthly child support or student loans (you don’t have to include bills for things such as groceries or utilities). Add your expected housing payments (your mortgage payments plus, for example, private mortgage insurance, homeowner’s insurance and property taxes) and divide the total by your gross monthly income.
Standard rule of thumb
A common rule when shopping for a mortgage is that your debt-to-income ratio should be no higher than 36 percent. Anything above this could mean you’ll be denied credit or charged a higher interest rate on your loan. Lenders also like the total of your housing expenses alone to not exceed 28 percent of your monthly gross income.
Exceptions to the rule
Some lenders will accept loans even if your ratio is above 40 percent, and there are certain mortgages that allow a higher percentage as well. Federal Housing Authority mortgages and Veterans Administration mortgages, for example, allow a debt-to-income ratio of up to 41 percent. With any loan, however, you need to be sure you are comfortable with the amount of debt you are accumulating. Keep in mind, the lower your debt-to-income ratio the better, so pay down as much debt as you can before starting the mortgage process.
Use the following worksheet to calculate your debt-to-income ratio:
Minimum monthly credit card payments*: _____________
+ Monthly car loan payments: _____________
+ Other monthly debt payments: _____________
+ Expected mortgage payments: _____________
= Total: _____________
Your debt-to-income ratio:
Total ÷ monthly gross income = _____________
*Your minimum credit card payment is not your total balance every month. It is your required minimum payment -- usually between two and three percent of the outstanding balance.