What are debt ratios?
In the commercial or investment real estate context, the debt ratio, also known as a debt service coverage ratio or debt service ratio, is the ratio of net operating income to debt payments. The higher this ratio is, the easier it is to borrow money to purchase or improve the property. In the personal finance context, a debt ratio is the ratio of personal debt to income.
The debt ratio is one of the most important factors used by mortgage lenders to determine whether to make a loan at all and the size of the loan. Ideally, the ratio will be greater than one. If it is greater than one, it means that borrower has enough income to pay all her debts and make other routine payments such as those necessary for utilities, food, and entertainment. If the buyer has a ratio of less than one, he does not have enough income to make his debt payments, let alone those other expenses. Not surprisingly, a lender does not want to lend to someone who does not have enough income to pay off all his debt. Instead, a lender prefers to see a ratio of about 1.3, which means that the borrower has about 30% more money than she needs to pay her debt - in other words, she has money to pay her debts and live on, too. Or, sometimes, the lender will make a loan to a person with a low debt ratio if the person has substantial assets or other income. For instance, a person with a low income, but significant stock portfolio may get a loan anyhow.
So, knowing that the bank likes to see a ratio of about 1.3, you can start to adjust your personal budget to hit that ratio if you are considering purchasing a home. People are often told that a good rule of thumb is to make sure that your debt is not more than about 35% to 42% of your income. It seems simple enough to remember this, but a buyer has to take a look at the math to make sure she isn't operating under a false sense of security. For example, let's assume a buyer has a monthly income of $3,000 and no debt. In this situation, the lender will make a mortgage loan of up to $1,000 per month because about $1,000 the buyer has the whole $1,000 available to pay off debt. Now, let's assume the buyer has $4,000 in monthly income and $1,000 in debt. Sounds like the buyer is in a good situation, right? After all, $1,000 in debt is only 25% of the monthly income. Well, one-third of $4,000 is about $1,333. However, the buyer already has $1,000 worth of debt that needs to be paid off monthly, so the bank will only make a mortgage loan of about $300 per month. That doesn't get the buyer much house. The lesson to be learned is that a lender will make a mortgage loan with a 1.3 debt ratio, but just because the lender will make it doesn't mean the buyer will be able to purchase a house.