Home loans

Your debt-to-income ratio is a personal finance measure that compares the amount of money that you earn to the amount of money that you owe to your creditors. For most people, when it comes to Home loans for high debt ratios, this number comes into play when they are trying to line up the financing to purchase a home, as it is used to determine mortgage affordability.

Calculating Debt-to-Income

Calculating your debt-to-income ratio isn’t hard and it doesn’t cost a dime. There are two main ways to calculate this depending on the debts included in the calculation.

The less strenuous way to measure high debt ratios for buying a home, is to compare all housing debts, which includes your mortgage expense, home insurance, taxes and any other housing-related expenses. Once you have the total housing expense calculated, divide it by the amount of your gross monthly income.

For example, if you earn $2,000 per month and have a mortgage expense of $400, taxes of $200 and insurance expenses of $150, your debt-to-income ratio is 37.5%.

The more encompassing measure is to include the total amount of money that you spend each month servicing debt. This includes all recurring debt, such as mortgages, car loans, child support payments and credit card payments.

When calculating this ratio, don’t count monthly expenses such as food, entertainment and utilities.

Gross Versus Net Income

For lending purposes, the debt-to-income calculation is always based on gross income. Gross income is a before-tax calculation. As we all know, we do get taxed, so we don’t get to keep all of our gross income (in most cases). Because you can’t spend money that you never receive, the result is a somewhat aggressive picture of your spending ability.

Consider the $2,000 per month gross monthly earnings example. After taxes at 2008 annual tax rates that imposed a flat rate of $802.50 plus 15% of the amount over $8,025, that $2,000 per is reduced to about $1,708 or less (depending on retirement plan contributions and other factors).

Despite the original debt-to-income calculation, you can’t pay your bills with gross income, and the net income (take-home pay) is less than the number used in the calculation. That’s nearly $300 that was used to help determine your spending ability but that won’t actually be there to work with when it comes time to pay your bills.

Don’t forget that, if you are in a higher income bracket, the percentage of your net income lost to taxes will be even higher. Regardless of your tax bracket, you’ll almost certainly be better served by a more conservative approach to your debt-to-income ratio calculation.
For anything other than loan eligibility, consider basing your calculations on net income rather than gross income. Using the net number provides a much more realistic picture of your ability to spend.