Debt Income Ratio Guidelines – What lenders actually look at

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Having been in the finance and loan industry for over a decade I have met with executives from dozens of financial institutions in helping them determine their debt income ratio guidelines. Whether it be the Help Desk, District Manager or the CEO and COO of the company there have been some striking similarities in their underwriting procedures, though they still vary immensely in how they go about coming to a decision.

Debt Ratio Calculations

For the most part the Debt ratio is determined from your monthly gross (before taxes) or take home income compared to the monthly liability payments that show on your credit report as well as your housing payment (rent or mortgage).

 

For example

  • Monthly expenses are $1000 ($600 rent, $200 auto loan, $200 credit card)
  • Monthly income : $4000
  • Your debt to income ratio would be 25%. ($1000/$4000 = .25 or 25%)

A healthy debt ratio is under 35%. Having a low debt ratio can show that you have disposable income to use and that adding more debt will not drastically change your current available income. Most lenders will allow borrowers to reach as high as 45% and others up to 50% but it seems like 50% and above is the limit. If you currently have a high ratio or one over 50% don’t despair as there are ways around it.

Is it really income?

Debts are the first part of the debt to income ratio, but the second part is the income. To receive a good ratio you can lower your expenses or increase your income. Which is easier to do in the short amount of time? Neither is ideal, but for most people lowering expenses (debt consolidation, balance transfers, early payoffs) typically is easier than asking for a bump in your pay.

One technicality to understand is to identify if the lender uses your documented or stated income in the application process. Before the great recession there was none or limited documentation required for most loans (consumer, auto and real estate). After 2008 all Real Estate loans now require documented income requirements, which means you show pay stubs and tax returns to prove the income you earn is correct.

However, most consumer and auto loans still only use the stated income requirement which is, what you declare on the application, your income. This can be a stretch especially since you can include other income sources (bonuses, rental income, dividends, resale) and your guesstimate typically becomes exaggerated to the actual amount. So an income of $4000/month could become stated higher trying to manually add in all the other sources of income that you may receive that year and average it out over 12 months.

Stated income should never become a place where you state a highly exaggerated income of say $300,000 when you currently make $60,000. Typically, when you sign the application there is an affidavit where you agree that what you have stated is true and correct. Also, the lender still has the right to request pay stubs and tax returns if they desire.

But if you can state your income relatively close, say within 15%, and your debt to income ratio isn’t extremely high then most of the time they don’t see any reason to call you out on proving your income.

 

Exceptions to the rule

While lenders try to streamline their process automatically there are ALWAYS exceptions to their policies and procedures. Some common exceptions are Child Support, Alimony, investment property mortgage (if owned and rented out), co-signer on a loan and the most common exception typically is student loan debts.

Student loans can be tricky depending on if you are currently or recently out of school and in the deferment payment period or if you are actively paying them back. While the student loan debt is in the deferred period it should not show as a monthly payment on your credit report, many companies choose to ignore any current monthly payments.

This student loan debt can be a shocking percentage! More and more students are graduating with mountains of debt. If you have massive student loan debt and they ignore it they could massively skew your actual debt ratio and hurt your financial flexibility. I would recommend contacting lenders beforehand to see how they handle student loan payments in your debt ratio.

Another exception will be anything that you will be paying off.

For example : Say you currently have a loan that has a minimum payment of $200 and you owe $600 left on it. If you are applying to get a new loan for $2000 and will use part of that new loan money to directly pay off the $600 balance, then the company will ignore the current $200 monthly payment. This is the debt consolidation approach, it especially works for real estate loans where you are refinancing to cash-out and consolidate debts. They will work with you much more if they can see it will be lowering your debt ratio.

 

Not my credit

When applying for a loan whose credit are they using? Typically, they will use the same people who are stating their income. This can become a loop-hole for single income families.

For example if there is a couple and only one individual has an income, then the application will only pull that individual’s credit. A lot of times they will push you to also include your spouse, but it’s not necessary unless they have income they are proving as well. So what’s the work-around.

Let’s say your current debt to income ratio is 35% which is becoming high and you want to be below 25%. If you are good at managing your money and paying all your debts on time you can quickly lower that ratio by doing a balance transfer to your spouse and having that debt sit on their credit. It can be ignored for any debt ratios because when they pull credit it will now show a $0 balance on your credit.

Another way around this can be if you have your own business (which we highly recommend), after you have been in business to become established then you can apply for business credit and that will remain independent from any personal credit inquiries.

How the Debt Ratio applies in the Loan process

While understanding your debt ratio can give you a decent amount of information prior to getting a loan it will not be the ultimate determining factor in the underwriting of the loan. The lender will still take into account a number of factors which may include : your credit score, if you pay your debts on-time or if you pay late, if you have any debts in a collection status, the time you have been with your current employer and at your current residence, as well as your previous history with that particular lender.

Remember to keep your ratio in check and relatively low to receive the best likelihood of getting approved for your next loan. What are some ways you can improve and lower you debt ratio?

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6 Comments

  1. Hello Marc,

    I have not particularly be a good lender because, my credit score is very low. I always pay back late because most of the time, I’m really sucked in. Like myself, I believe most people put fake incomes when applying for a loan, and this in turn affects the ability to pay the loans back. Basically, to avoid unnecessary loans, I have cut down my expenses to the barest minimum, and I’m also looking for ways to increase my income by working online 

    • Oh Louis, we need to help you clean up your credit score and eliminate those loans.  They make it so easy to get it started.  If you read some of the fine print for some of the credit cards they’ll auto approve you if you just claim to make at least $20,000.  

      Use the snowball payment plan and get it back to where it’s manageable and focus on sticking to the plan, increasing your income and putting all that windfall income to work for you.  It’s going to be a great journey that you can look back and be impressed at what you’ve accomplished.  Best of luck to you.   

  2. Lots of interesting info in this post.  I find it intriguing that financial institutions vary so much in reaching a decision through their underwriting.  

    Good description of debt ratio calculations and how a good ratio in under thirty five percent even though you say some lenders will accept up to fifty percent.  

    Then there’s the income requirements and of course there are exceptions to the rule.  It can get quite confusing.

    But thank you for the clarification and a better understanding of how the debt ratio actually works in the loan process.  Much appreciated.

  3. Wow! This is an informative blog post.

    Thanks for opening my eyes to see what most lenders consider before lending. The debt ratio is truly a giant factor and I cannot but agree with what you have written here especially where you highlighted the fact that to reduce debt ratio, one has to cut down the expenses or increase his/her income. Cos these day these days income with debt ratio above 50% might not be easily considered for loan. Nice article!

    • Thanks for the comment.  Yep it’s just one of the main factors used and won’t guarantee you’ll get approved but at least you won’t get automatically flagged if it’s too low.  You need to show you can already use credit wisely to get more of it.  

  4. Wow! This is an informative blog post.

    Thanks for opening my eyes to see what most lenders consider before lending. The debt ratio is truly a giant factor and I cannot but agree with what you have written here especially where you highlighted the fact that to reduce debt ratio, one has to cut down the expenses or increase his/her income. Cos these day these days income with debt ratio above 50% might not be easily considered for loan. Nice article!

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