Debt ratios are used to figure out how much you can afford
The two most commonly used debt ratios are debt-to-income ratio and loan-to-value ratio. The debt-to-income ratio is applied first to determine the maximum amount you can borrow and then the loan-to-value ratio is applied next to determine that maximum price you can pay to purchase the item you are seeking to buy.
The debt-to-income ratio is considered first because this ratio tells you how much you can borrow based on your monthly income minus your monthly debt payments.
To calculate your debt-to-income ratio you must first total up all your sources of monthly income. Then you must total up all your monthly debt payments. Finally, divide your total monthly debt payments by your total monthly income to get your debt-to-income ratio and multiply that number by 100 to get the percent.
Add up your monthly income (salaries, overtime, dividends, etc)
Add up your monthly debt payments (mortgage or rent, credit card minimum payments, car loan, student loans, alimony/child support, other loans, etc)
Then calculate your debt-to-income ratio:
Monthly debt payments / Monthly income x 100 = Debt-to-income ratio
So, let’s say your total monthly income is $5,500 per month and your total monthly debt payments is $3,100. Your debt-to-income ratio would then be calculated as follows:
$3,100 / $5,500 x 100 = 56%
Your final result will fall into one of these categories:
- 36% or less is the healthiest debt load for the majority of people.
- 37%-42% isn’t a bad place to be. If your ratio falls in this range, you should consider reducing you your debts
- 43%-49% is a ratio that indicates likely financial trouble. Start paying off your debts now to prevent an overloaded debt situation.
- 50% or more is a dangerous ratio. You should be aggressively paying off your debts. Don’t hesitate to seek professional help.
The loan-to-value ratio is calculated by dividing the loan amount by the property’s value. This ratio is used to determine how much money you can borrow based on the value of the property.
To calculate the ratio you first need to know the market value of the property you are seeking to borrow against. To get the market value, the creditor will typically require you to hire a qualified appraiser to prepare an appraisal report of market value.
So for example let’s say you are applying for a loan for a house and it is determined by an appraiser that the market value of the house is $200,000. You now have the first number of the equation.
Next, you need to know what ratio the creditor is willing to work at. Most creditors will lend up to 80% to 90% of the value of the property. So now you have the second part of the equation.
To put it all together here is the calculation to determine how much you can borrow:
Market value of property $200,000
Creditors given rate x 80%
Maximum Loan Amount $160,000
Now you have to calculate the amount of funds you will need on hand to complete the loan agreement. This is simple. Simply subtract the Market value of the property from the Maximum Loan Amount to get the amount of deposit you will need to have to get the loan. So for example:
Market value of property – Maximum Loan Amount = Deposit Amount Required
$200,000 – $160,000 = $40,000
Creditors work at different rates so a creditor who works at a 90% loan-to-value rate means that you will need less of an initial deposit. This is one reason why you should shop around.
Now you have successfully calculated the maximum amount of money you can borrow.
Don’t be afraid to start small. Just because you may qualify for a large loan doesn’t mean that it is a smart financial decision to buy as large a home as possible. Take a careful look at your family budget and your housing needs before you decide how much you can really afford.