When making a loan application, whether for a mortgage, auto loan, or personal loan, people worry about being approved. They worry about their credit history, and how it’s going to affect their approval. What most people usually don’t consider is their debt-to-income ratio. This can be a costly mistake, as it is one of the primary factors that lenders consider for approval. For example, you may not think about something like “does a car lease count as debt?” when it comes to your debt ratio, but depending on your financial situation, almost anything can factor in if the lender believes it to be necessary.
What is a debt ratio? It is your total monthly debt divided by your total income. For example, if you pay $1,000 per month in bills and your income is $3,000 per month, your debt ratio is 1000/3000 or 33%. In other words, about one-third of your total income is taken up by monthly bills.
More goes into this equation, however. Lenders usually calculate your debt ratio using your gross monthly income. Some, though very few, will calculate debt ratio with net income. If they do use net income, they will usually take 75% of your gross income.
On the debt side of the equation, usually only debts that are reported on your credit report are counted against your debt ratio. That means, for example, your car insurance payments or your gym memberships aren’t taken into account. As well, many utility companies, such as electrical, gas, and water, will report your monthly payments on your credit report. However, utility bills and cell phone bills are usually not counted against debt ratio, even if they are on the credit report. In any case, debt ratio is not a good indication of your debt levels. For example, does a car lease count as debt? It is a payment you make regularly, just like gym memberships and utilities, but it is not a traditional type of debt like credit card debt or loans. With this type of debt, it may just depend on the person looking at your finances as to whether they will include it as debt or not.
How does debt ratio affect your approvals? Lenders have different criteria for debt ratio. They might give a front end/back end ratio of 28/33. This ratio means that no more than 28% of your gross income can be allocated towards a mortgage payment. As well, your total debt load, including your credit cards, auto loans, and the new mortgage, cannot exceed 33%.
This ratio has several implications. First, the value of the house you can shop for cannot exceed a certain amount. Second, if you have a high debt load, it will limit your price range. Further, if you have an extremely high debt load, your debt ratio will not support any kind of price on a house. In other words, you’ll be denied no matter how good your credit if you have too much debt. This is the power of the debt ratio.
Debt ratio is not a good indicator of what you can or cannot afford. Debt ratio only applies to what the lender sees on paper. If you have a side business that generates a good amount of income, you might be able to afford a house in a higher price range. However, without the proper documentation, lenders cannot count your business income.
What can you do about debt ratio? You have a couple of options, but both point to manipulating your ratio in some way. First, you can pay down your debts. By paying down or eliminating some debts, you can improve your debt ratio and increase your buying price range. Obviously, the higher the payment you can knock out, the better for your debt ratio.
Here’s a trick you can use to better your chances. For most people, the highest payment on their credit report, outside of a house payment, is a car payment or other type of installment loan. Many lenders will not count an installment loan against your debt ratio IF there are less than 10 payments remaining. If there is any possible way for you to pay down your installment loan to fewer than 10 payments, your debt ratio will improve dramatically. For example, if you have a car loan that has 13 payments left, you don’t have to pay off the entire loan to enjoy the improved debt ratio. You simply need to pay 3 payments; worth to get the balance down. Does a car lease count as debt? As it is not a loan, it is not technically debt, but it might depend on the lender as to whether they want to take it into account when calculating the debt ratio.
Three caveats to this trick. First, this only works if the lender utilizes the 10 payment rule. Second, this only applies for installment loans; that is, loans that have a fixed term and fixed monthly payment (car loans, student loans, and some personal loans). You cannot use this rule against credit cards and other revolving lines of credit. Third, most lenders will not apply this rule to a car lease, so even if you have less than 10 lease payments remaining, it will count against you. The lease payment rule is not industry-wide however, so check with the mortgage company.