Debt Ratios

HOW MUCH CAN YOU prudently borrow? You might check on yourself the way a banker would. If you apply for a mortgage, lenders will often assess your borrowing ability using two key measures: your housing and debt ratios.

The housing ratio looks at your expected or current monthly mortgage payment, including principal, interest, property taxes and homeowner’s insurance. As a rule, this shouldn’t be more than 28% of your pretax monthly income. For instance, if you earn $60,000 a year or $5,000 a month, your total mortgage payment shouldn’t be above $1,400.

The debt ratio looks at all your debt payments, including mortgage, auto loans, student loans and minimum credit card payments. If you’re divorced, the debt ratio will also include any child support and alimony you pay. Typically, these various obligations shouldn’t be above 36% of your gross monthly income, which would equal $1,800 if you earn $5,000 pretax every month, though some lenders will accept debt ratios that are significantly higher. What if you apply for a mortgage and you don’t have any other debts? A lender may be willing to lend you more, so your monthly mortgage payments are above 28% of your gross income.

Even if you aren’t applying for a mortgage, keep these ratios in mind. For instance, the difference between the housing ratio’s 28% and the debt ratio’s 36% is eight percentage points. The implication: Lenders don’t want borrowers devoting more than 8% of their gross income to nonmortgage debt. Let’s say you are taking out an auto loan. You might calculate whether the auto loan will push your nonmortgage debt payments above 8% of income. Alternatively, imagine you’re advising your children on college borrowing. You might calculate whether your children’s eventual student-loan payments will be more than 8% of their likely income.

Next: Secured vs. Unsecured

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