Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Qualification Ratio

What it is:

A qualification ratio is actually two ratios that banks use to determine whether a borrower is eligible for a mortgage. The two ratios generally are:

Total Borrower Debt/Monthly Income

Borrower's Total Monthly Debt Payments/Monthly Income

How it works (Example):

For example, let's assume that Borrower X has $4,000 of monthly income and $30,000 of student loans and credit card debt, on which he pays $600. Borrower X wants an 8%, 30-year, $250,000 mortgage. The monthly payment on that mortgage, including homeowners insurance and property taxes, works out to $2,200.

Using this information and the formulas above, the bank can use qualification ratios as part of its determination of whether Borrower X is a good lending risk.

Total monthly borrower debt payments/monthly income = ($600 + $2,200)/$4,000 = 0.70

Borrower's monthly housing expense/monthly income = $2,200/$4,000 = 0.55

Why it Matters:

Qualification ratios are intended to reduce banks' risk of default. Each lender has its own standards, though a rule of thumb is that total debt payments to income should not exceed 0.36 and housing expenses to income should not exceed 0.28. (Borrower X in our example exceeds those thresholds and thus probably won't get the loan.) Borrowers that do not meet banks' minimum qualification-ratio thresholds usually either do not receive loans, must make larger down payments, or must pay higher interest rates.

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