Thinking like a lender: how to make sense of your debt load.

Thinking like a lender: how to make sense of your debt load.

Looking to buy a new home, refinance or tap into your home equity? Congratulations! Making a big purchase or moving to a new stage in life can be an exciting time. But, let’s be honest, it can also be a little overwhelming, especially if you’ll need a loan.

Before they’ll give you a loan, banks and lenders want to make sure you’ll be able to repay it. It’s why they’ll calculate your debt-to-income ratio. It might feel like they’re going through your financial history, but it’s for good reason: lenders pay close attention to your debt load to determine that you make enough money to afford the payments.

Fortunately, you can arm yourself with this information before you ever head to an open house or decide on a home equity line of credit. By calculating your own debt-to-income ratio, you’ll put yourself in a position to shop with more confidence since you’ll know exactly what you can afford to repay every month.

Understanding the Basic Guidelines

Lenders typically rely on two debt-to-income ratios, depending on the type of loan.

The first one, your front-end debt-to-income ratio, is the percentage of your monthly income that your total housing payment -- including principal, interest and taxes -- consumes. Generally, lenders want your monthly housing payment to take up no more than 28 percent of your gross monthly income.

The second, your back-end debt-to-income ratio, is the percentage of your monthly income that all of your debts take up. This includes everything from your mortgage payment and car loan, to student loans and minimum monthly credit card payments. Lenders want your total monthly obligations to equal no more than 36 percent of your gross monthly income.

Finding Your Personal Debt-to-Income Ratio

Let’s start by calculating the maximum amount you should spend on monthly debt payments. First, determine your gross monthly income by dividing the total amount you make yearly (before taxes) by 12. For example, if you earn $36,000 a year, your monthly income is $3,000. Now multiply your monthly income by 36 percent. For $3,000 of monthly income, it comes out to $1,080. That’s the maximum amount you should spend each month on all of your debt payments.

If you’re under the maximum amount, that’s good news. It means you should be able to comfortably afford taking on new debt. And you’ll have a pretty good idea what a new monthly loan payment could be.

But what if you’re already spending more than the maximum amount? Then you’ll want to calculate your back-end debt-to-income ratio to determine how much you are paying on debt each month.

To start, add up all of your monthly payments. Credit cards, mortgages, car loans, and student loans—include any loan payments you make each month. Don't include household expenses like groceries or utilities. Next, divide that amount by your monthly gross income. This will give you debt-to-income ratio. For instance, if you’re spending $1,000 on debt each month and your gross monthly income is $2,500, you have a back-end debt-to-income ratio of 40 percent. Many lenders will find this number too high.

You have two options when it comes to reducing your debt-to-income ratio. You can either boost your gross monthly income or reduce your monthly expenses. Whatever approach you take, know that lenders of all kinds will pay close attention to your debt load. Make sure, then, that you do the same.

Need to speak with somebody about a home loan? Get in touch with one of the knowledgeable mortgage loan officers at Liberty Bank.


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