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.