What is debt ratio?

When applying for a mortgage loan, the lender often talk about the debt ratio and how that affects the outcome of your mortgage application. So, what is debt ratio? Many people misunderstand what a debt ratio is when they find out about their debt ratio from different sources.

What is debt ratio?

A debt ratio is a percentage of debt compared to income. For example, if you have a debt ratio of 10 then your bills are 10% of your gross monthly income. Note that without specifying the nature of the debt ratio, you have to figure out from the context what the debt ratio is. Debt to income ratio is one of the most common debt ratio, along with debt to equity ratio used in the real estate industry.

How lenders use debt ratio to determine how much you can borrow

Over the years, mortgage lenders have established guidelines based on historical data that tells them which debt ratios allow them to lend the most to a mortgage loan applicant and also make sure that the mortgage loan is not excessively risky for the lender.

Debt ratios help mortgage lenders lend as much as possible to mortgage applicants and still face very low risk of having to foreclose on the properties. This is also good for mortgage applicants because it spares them the risk of having to go through foreclosure should they fall into default and cannot pay the mortgage payments.

A debt ratio benefits both lender and homeowner

The mortgage lender is in business to lend money. Naturally, the mortgage lender would like to lend as much as possible. However, the mortgage lender also has to ensure that the lending decision is a good one meaning they wouldn't have to foreclose on the homes later. Since foreclosure costs money and the debt to a homeowner in foreclosure is a bad debt that stays on the bank's books for a long time while tying their reserves up the whole time. The reserves would otherwise have been used to lend to other homeowners making more money for the bank. So, while the bank wants to lend as much as possible, the bank has to ensure that the homeowner can pay the mortgage payments in the timely manners.