The Purpose of Debt Ratio

Debt ratios are particularly important when applying for home loans.
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In personal finance, debt ratios measure different aspects of your financial health and how well you may be able to handle additional debt. Many lenders look at various debt ratios when deciding whether to issue new loans. Two common debt ratios are the debt-to-assets ratio and the debt-to-income ratio.

Debt-to-Assets Ratio

The debt-to-assets ratio measures the amount of money you owe in debts to the value of your assets. A ratio greater than one means you owe more money than your assets are worth. A ratio less than one means your assets are worth more than your debts. For example, if you have $90,000 in assets and $45,000 in debts, divide $45,000 by $90,000 to find your debt-to-assets ratio equals 0.5, or 50 percent.

Debt-to-Assets Limits

Debt-to-asset limits become especially important when you are taking out a second mortgage or home equity loan. A second lender will usually not want to make a loan that exceeds the value of the home. In addition, many lenders want to have a cushion, or value above the amount of the loan, so the limit the total debt to a percentage of the home's value. For example, if your home is worth $340,000, you have a $200,000 mortgage, and the lender is limiting your total debt to 75 percent of the value, your home equity loan would be limited to $55,000.

Debt-to-Income Ratios

The debt-to-income ratio measures your monthly payments on your debt to your monthly income. This ratio is often used by mortgage lenders to determine whether you can afford a mortgage. One debt-to-income ratio is the front-end ratio, which just measures your expected monthly payment to your monthly income. The back-end ratio measures all of your debt payments, including your car loan, student loans and expected mortgage payment, to your monthly income.

Limits on Debt-to-Income

Lenders often limit the amount people can borrow for a mortgage based on their debt-to-income ratio. Although limits vary by lender, most lenders limit the front-end ratio to between 0.28 and 0.33, or 28 to 33 percent of your monthly income. For example, if you make $3,700 per month, your monthly mortgage payment would generally be limited to between $1,036 and $1,221. The back-end ratio is usually limited to 0.36, or 36 percent of the debt. For example, if you have a $3,700 monthly income and a $300 monthly car payment, your back-end ratio would limit the mortgage payment to $1,032.

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