Understanding Housing and Debt Ratios

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Understanding Housing and Debt Ratios

You've found your dream home in the perfect neighborhood.

There's just one problem: You do not know if you can afford the monthly mortgage payments that will come with the home.

Fortunately, there are debt ratios that you can use to determine whether the home you want is also one that you can afford. By studying these ratios, you'll avoid taking out a home loan that will put you in a precarious financial situation.

Debt-to-income ratio

Your debt-to-income ratio, also known as your back-end ratio, is also important. This ratio tells you how much of your monthly salary is eaten up by all of your expenses, including housing. Your expenses would include any recurring payment, such as your mortgage loan, car payment, student loan payment, credit card debt and child support.

You want your total monthly debts to account for no more than 41 percent of your monthly income.

To determine your maximum affordable debt-to-income ratio, multiply your annual salary by .41 and divide the resulting figure by 12. For that $50,000 annual salary, the maximum amount of monthly debt obligations you'd be able to afford would be $1,708.33. Remember, that figure includes your mortgage payment including real estate taxes, homeowner's insurance, and private mortgage insurance if applicable, and all other monthly debts.

Loan-to-value ratio

There's one more ratio you need to know when buying a home. This one, though, determines whether mortgage lenders will approve you for a mortgage for purchasing or refinancing a home.

The loan-to-value ratio spells out exactly what percentage of a home's value you are asking to finance. When purchasing a home, most private mortgage lenders will want you to put down a down payment of at least 5 percent of a home's value, although some government insured loans will allow for lower down payments. This will leave you with a loan-to-value ratio of 95 percent. You are asking the lender to finance 95 percent of your housing purchase.

If you want to eliminate the private mortgage insurance requirement that comes with mortgages with down payments less than 20 percent, you'll need a loan-to-value ratio of at least 80 percent.

If you want to refinance your home loan, you'll typically need a loan-to-value ratio of 90 percent or lower. There are programs though, some offered through the federal government, that allow owners with higher loan-to-value ratios to apply for a refinance.

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