Your debt ratio is a rate that compares your monthly debt against your monthly income.
What is a debt ratio?
In the mortgage business, two common debt ratios are used to evaluate a borrower’s capacity to repay a loan or mortgage. These are the gross debt service ratio and the total debt service ratio.
What is the gross debt service ratio?
The gross debt service ratio or GDS is the rate of your monthly housing costs compared to your gross monthly income, or your income before taxes and deductions. A borrower’s most considerable monthly expense is likely his mortgage payment. Your GDS is a helpful indicator of whether you can afford your home.
When calculating your GDS, the ratio takes into account more than your mortgage payment. Your housing costs include your mortgage payments, home insurances, utilities, and property costs. An ideal GDS is 28% or less, but GDS limits vary by loan type.
For example, let’s say you have a gross monthly income of $4,000 and you want to apply for a mortgage. The lender would look at the $1,000 mortgage payment, $200 property taxes, and $200 in utility bills. Your housing costs total $1,400. To calculate your GDS, divide $1,400 by $4,000 and convert it into a percentage. Your gross debt service ratio is 35%.
It appears that your GDS is a bit high. You may not be able to afford the home in your current situation.
A few alternative names for your GDS is the “Housing Expense Ratio” and “Front-end Ratio.”
What is the total debt service ratio?
The total debt service ratio or TDS is similar to the gross debt service ratio. The main difference is that the TDS takes into account all your monthly debt payments. Your TDS ratio supplies lenders with an overview of your previous financial commitments to determine how well you manage your monthly debts. This evaluation translates into how well you will be able to afford to repay a new loan.
When calculating your TDS, you must include all recurring monthly bills. For example, add up your rent or mortgage payments, all outstanding loans (student loans, personal loans, auto loans), credit card monthly minimum payments, and any other financial obligations, such as child support or alimony. This number divided by your monthly gross income is your total debt service ratio. For a qualified mortgage, an ideal rate is 36% or less. This threshold will also vary depending on the loan type.
For example, let’s say your gross monthly income is $3,000. Your car payment is $250, your credit card minimum payments total $50, and your current rent is $750. Your total monthly debt is $1,050. $1,050 divided by $3,000 is 0.35 or 35%. Congratulations! You will likely qualify for a mortgage!
A few alternative names for your TDS is the “Debt-to-Income Ratio” (DTI) and the “Back-end Ratio.”
Significance of Debt Ratios
Lenders will look at one, if not both, of your debt ratios to evaluate if you are a trustworthy and suitable borrower. These are not the only factors that determine your loan eligibility. However, the lower your debt ratios, the more appealing you are to lenders.