What you need to know about debt ratios

More about debt ratios

In the midst of a pandemic, people around the globe have found a personal escape on a deserted island. They collect fruit, fish, and catch bugs to make money and build their island. They can travel to other islands and connect with friends around the globe on their own deserted islands. If you’re confused, we’re talking about the popular Animal Crossing video game. While allowing friends to connect, Animal Crossing also teaches some pretty valuable skills and lessons. The game teaches all age groups the value of money and paying off loans.

Throughout the game, you are paying back a loan on your house. To increase the size of your house and add rooms, you must take out a loan. Whether consciously or unconsciously, you assess your own risk. You calculate how much money you are making per day and the time it would take you to pay off the loan. You assess any other debts you have and factors that would delay your loan payments. In the real world, lenders assess your ability to pay off a mortgage. They look at a plethora of factors that qualify a borrower for a mortgage but pay special attention to your debt ratios.

What is the debt-to-income ratio

A debt-to-income ratio is a tool that lenders use to evaluate your ability to meet your debt obligations on a monthly basis. The ratio compares a borrower’s monthly debt to their gross monthly income. Recurring monthly debts can include things like other loans, credit card payments, and car payments. Your gross monthly income is the amount you make before expenses and taxes. The higher your monthly debt obligations in relation to your income, the higher the ratio. The lower the monthly debt in relation to income, the lower the ratio.

Interpretation of your ratio

A lower debt-to-income ratio, put simply, means you are using less of your income to pay off existing debt. Your ratio is used by lenders to show whether you are capable of making your debt payments. These ratios can also highlight how dependent on your income you are to make these payments. Borrowers with a lower amount of debt in relation to their income are seen as having an easier time paying off a loan than someone with high debt. Lenders evaluate a borrower’s gross debt to service ratio (GDS) and total debt service ratios (TDS).

What’s the difference between your GDS and TDS?

Your GDS looks at how your income relates to your monthly housing expenses. Lenders will then look at your total debt service ratio. This evaluates your monthly housing expenses and other debt payments- like credit cards- you would make each month. Potential borrowers that already have a high amount of debt may find it harder to take on additional debt. It becomes harder for you to reach their financial obligations when you carry high amounts of debt.

By keeping your debt ratios low you are showing the lender that you are able to properly manage debt. Simply put, you display that you are able to live within your means. This helps increase the confidence that you will be able to repay your loan, on time, every month.

How to lower your ratio

Lenders look for a low debt-to-income ratio to ensure that you will be able to repay your loan. Your total housing costs, otherwise labeled as GDS, which include principal, interest, taxes, and heat, should be less than 36% of your pre-tax income. Your total debt obligation, which is calculated as your GDS plus other debt payments, should be less than 43% of your pre-tax income. Improving your debt-to-income ratio can impact the way a lender assesses you.

There are only two ways that you can lower your ratio. You can increase your income or reduce the amount of outstanding debt. Limiting new debt and paying down your current debt will easily lower your ratio. This will make you look like a more attractive borrower. Evaluate your monthly expenses and look for the non-essentials. Limit the number of nonessentials and use the money to pay off your current debt.

Planning your financial future

Consolidating high-interest debt into a loan with a lower interest rate will help you pay down your debt sooner. This can also improve your debt-to-income ratio by reducing your monthly debt obligations. The lower your debt-to-income ratio, the easier it is to meet your financial obligations. We find it easier to pay off our debts when we keep our ratio low and manageable.

Paying off debt and keeping our debt ratios low helps us to progress in aspects of our life with ease. We find it easy to pay off debt, which allows us to reach future financial goals that we’ve set out. When looking at how your debt-to-income ratio can impact your mortgage application, give us a call at Centum Home Lenders! You can give us a call at 506-854-6847 or get in touch with us here!