What is a Qualification Ratio?

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 Does a Qualification Ratio Work?

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

[If you're ready to buy a home, use our Mortgage Calculator to see what your monthly principal and interest payment will be. You can also learn how to calculate your monthly payment in Excel.]

Why Does a Qualification Ratio Matter?

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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Paul Tracy
Paul Tracy

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

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