Some people are able to purchase a new property without borrowing any money, but most consumers will normally turn to a mortgage lender to help them secure a new home. When approving a mortgage, lenders consider several factors, including your current debt ratio. Learn how lenders calculate your debt ratio, and find out how to manage this financial measure to secure the best possible loan.
Debt ratio definition
The debt ratio is a measure that accountants often apply to businesses, but the term is also relevant for consumers. A lender calculates your debt ratio by dividing your total monthly borrowing commitments (debt) by your monthly income and expressing the result as a percentage.
For example, if your monthly income is $4,000 and your proposed mortgage payment is $2,000, your debt ratio is $2,000 / $4,000 or 50%.
How banks use debt ratios
As part of their lending criteria, banks will normally set a debt ratio, above which they will not normally agree to lend you money. Banks do not publish details of their lending criteria, and each company works to a different debt ratio threshold. That aside, a financial advisor can normally help you understand the sort of debt ratio each of the big banks works to.
In Australia, all mortgage lenders must meet the requirements of the National Consumer Credit Protection Act (NCCP). These far-reaching regulations cover every aspect of lending, but, in particular, banks must take steps to make sure they don't let people borrow too much money. Debt ratios help banks prove that they use robust credit assessment methods.
Of course, the debt ratio is only one of the criteria that banks use, but it is an influential part of the process.
The pitfalls of debt ratios
Even a moderate amount of debt can materially impact the amount of money a bank will lend you for a mortgage. In some cases, banks work to a relatively modest debt ratio, which means that a consumer with an existing bank loan or credit card payments could find it difficult to get the mortgage he or she wants.
One of the big challenges is that the bank must include the proposed monthly mortgage payment in the numerator for the debt ratio. As such, even a small amount of debt can seriously scupper somebody with a modest income.
At a 38% debt ratio, somebody with a $3,000 monthly income and no debt could afford mortgage payments of $1,140 per month. However, at the same ratio, somebody with a $4,000 monthly income and $1,000 debt could only afford a mortgage payment of $520 per month, even though he or she has the same income after debt.
Deciding if you should cut your debt ratio
To get the mortgage you want, you may need to pay off some (or all) of your debt, so your debt ratio meets the bank's requirements. In some cases, financial advisors warn against this practice because you can use up valuable cash reserves that you need for your down payment.
As a rule of thumb, your current debt ratio will dictate whether you should pay off borrowing, or use cash for your down payment.
- If your current debt ratio is 6 percent or less, you shouldn't worry about paying off debt, as it is unlikely to affect the bank's decision.
- If your current debt ratio is less than 20 percent, you should keep your cash if you need it for your down payment. A larger down payment could help you secure a better interest rate and will help you keep your mortgage repayments down.
- If your current debt ratio exceeds 20 percent, you will probably need to pay off some of your borrowing to get the mortgage you need.
In all cases, an independent financial planner can help you explore the options you have.
When you apply for a mortgage, a bank will consider many aspects of your credit worthiness. You current debt ratio is an important part of this process, so it's important to carefully consider the best way to go about borrowing money and paying off debt.