Debt vs. Income: What You Need to Know
Income is a crucial component lenders consider when granting you a mortgage. However, income is not all that a lender will consider when determining how much you qualify for. They will also look at your debt to income ratio, in addition to other financial indicators.
If you make a lot of money but also have a lot of debt, this could be a red flag to lenders and reduce your borrowing capacity.
How debt & income affect your mortgage
Income and debt are yin and yang, opposites of each other. Debt is a liability, whereas the more income you have, the more power you have to make those liabilities go away. Having more income also gives more control of the following.
- It allows you to prepay your mortgage faster.
- It allows you to qualify for more when buying a home.
- It allows you to move into a shorter and more aggressive debt pay-down structure such as a 15-year fixed-rate mortgage.
- It allows you to pay off your credit cards in full every month, rather than paying unnecessary and pricey interest (assuming you’re making smart financial choices).
- It allows you to consume smart debt, such as purchasing a rental property that can generate even more income.
- It allows you to make investments, generating more income.
- It allows you to save and plan for the future.
Having this control over these and other financial choices is precisely why it is CRUCIAL to carry a debt-to-income ratio no bigger than 36% of your gross monthly income. The goal when borrowing mortgage money is to put yourself in a position where you can have a life beyond paying it off, while still saving and contributing to your retirement savings.
What you need to consider before you buy
Always remember it takes $2 of income to offset every $1 of debt for a 2:1 ratio for mortgage qualifying purposes.
If you want that fancy Mercedes at an $800 per month car payment, then you’ll need $19,200 a year in extra income or you’ll need to cut a current debt payment of $800 to balance your debt-to-income ratio.
If you want the dream house at $3,500 month, then aim your debt-to-income ratio at 36%—meaning you would ideally want income at $117,000 a year without carrying other consumer obligations in order to afford this mortgage.
When you are thinking about buying a home, also remember to consider what the future holds for your finances. For example, if your monthly expenses will likely increase in the future due to expenses like childcare costs or college tuition, this is something important to keep in mind. By keeping your debt to income ratio below 36% of your gross monthly income, you’ll put yourself in a position to enjoy your new home but also be able to continue saving for your future.