What are Qualifying Ratios?
Qualifying ratios are ratios banks use to determine whether a borrower is eligible for a mortgage.
How Do Qualifying Ratios Work?
The two qualifying ratios banks generally use are:
Total Borrower Debt / Monthly Income
Borrower's Total Monthly Debt Payments / Monthly Income
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.
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Using this information and the formulas above, the bank can use qualifying 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 Do Qualifying Ratios Matter?
Qualifying 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 qualifying ratio thresholds usually either do not receive loans, must make larger down payments, or must pay higher interest rates.