Explanation of a Debt to Income Ratio, The banks Method vs. Your Method, Which should you use?

If you’re in the process, or have been through the process, of getting a mortgage then I’m sure you’ve heard the term Debt to Income Ratio. This ratio can be found in two different ways; Your way and the banks way. I recommend “your way” instead of the banks because you can easily see what you can afford for a monthly mortgage payment. When figuring out this number make sure you remember taxes, insurance and new expenses.

The Banks way

The reason I don’t recommend this formula is simple, you know your bills better than the bank does! Your Debt to Income Ratio is all of your monthly expenses (debt) divided into your gross monthly income. Debt = 1100/mo divided by Income = 2600/mo which is 42%. Most banks don’t approve a mortgage if your total debt including the new mortgage is over 46-49%, if you get over that percentage you might be able to get a caution mortgage loan. So what happens is, the bank takes half of your gross income.

Ex. 50,000/12 months = 4,166.00 available to spend. Then mortgage company, or bank, will then run your social security number to see if you have any debt or existing loans to your name (car loan, college loans, mortgage, rent, etc.). They already account for your new mortgage payment, taxes, insurance and home expenses (heat, electric, water, cable, etc) by accounting for no more than 50% of your gross income. Let’s assume the banks finds $1650.00 worth of loans and bills for you. They would take 1650/4166 = 39%. You’re approved! That’s assuming you have good credit and a clean mortgage history of course.

Your Way

This is simple! First add up every monthly expense you can possibly think of (1000.00), and every dollar you make monthly after taxes (3,125.00). I would take off about 200-300 for spending / Way to save money from that 3,125 to make 2,825 – 1000 = $1,825.00 available for you new home. Make sure you account for your new mortgage payment, taxes, insurance and if there’s a condo fee then include that too. Then take a look at a mortgage calculator to realize how expensive of a house you can afford and look in that range.

You know you bills, expenses and spending habits better than anyone else, so it’s up to you to be honest with yourself about what you can afford for you monthly mortgage payment. Just because the mortgage company says you can afford something it doesn’t mean you can. So be careful and use a mortgage calculator to analyze what you’re comfortable spending each month on your new home.

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