Definition and Examples of Qualifying Ratios
A qualifying ratio is a percentage lenders use to determine whether or not a borrower can reasonably repay their loan. The exact requirements can vary depending on the lender, and this ratio is usually considered alongside a borrower’s credit score and other factors to determine eligibility. For instance, the debt-to-income ratio is one metric mortgage lenders use to qualify a borrower for a home loan. A debt-to-income ratio looks at the percentage of a borrower’s income that goes toward monthly debt payments. Fannie Mae, which buys conventional mortgages, allows for a maximum debt-to-income ratio of 45%, although up to 50% is permitted with additional compensating factors.
How Qualifying Ratios Work
Improving your qualifying ratios is the first step toward improving your chances of being approved for a mortgage. Lenders will often consider both your qualifying ratios and your credit score when evaluating you for a loan. For instance, if you are applying for a mortgage, your lender will look at both the front-end and the back-end ratios. The front-end ratio is often referred to as the mortgage-to-income ratio. This ratio is the percentage of your income that is allotted for mortgage payments. This is calculated by dividing your monthly mortgage payments by your gross income. Most lenders prefer that the front-end ratio is no higher than 28%. For instance, let’s say your anticipated monthly mortgage payments, including insurance, taxes, and private mortgage insurance (PMI), are $1,700, and your gross monthly income is $6,000. Your front-end ratio would be 28%, so you’d just make the cut. In comparison, your back-end ratio considers how much of your monthly income goes toward all of your debt payments. This is usually referred to as simply the debt-to-income ratio, and it will typically be higher. Your debt-to-income ratio will include things like your mortgage, student loan payments, auto payments, or credit card payments. Continuing with the above scenario, let’s say you also have a monthly student loan payment of $500. That brings your total monthly debt payments to $2,200. When you divide this number by your monthly gross income, you get a debt-to-income ratio of 37%.
Types of Loan Requirements
Qualifying ratios can vary depending on your lender, and they can also vary depending on your loan program. For instance, standard loan products often use a debt-to-income ratio to evaluate a borrower. Meanwhile, mortgage lenders will consider both your mortgage-to-income ratio and debt-to-income ratio. Here’s what you need to know about different types of lending products.
Personal Loans
When you apply for a personal loan, your lender will usually look at your credit score and debt-to-income ratio. Credit card companies will also typically look at a borrower’s debt-to-income ratio and credit score. If you want to qualify for the best rates and repayment terms, you should aim for a debt-to-income ratio below 36%. However, some lenders will accept a debt-to-income ratio of 45% or higher.
Mortgages
Mortgage lenders will typically look at a borrower’s mortgage-to-income ratio and debt-to-income ratio. And it’s important to keep in mind that your mortgage-to-income ratio includes all of your housing-related expenses. For instance, if you pay monthly HOA dues or property taxes, this could count toward your mortgage-to-income ratio. If either ratio is higher than you would like, focus on paying down debt before applying for a mortgage.
