Fiction writers use words to convey a story. If they are skilled, the words used can draw us into the events so much that you might have a hard time stopping yourself from reading well into the night. For some they need to know if their conclusions about the plot are correct. Others empathize with the characters. It’s as if they have stepped into another reality and left this world behind. Great writers can take our emotions on a grand excursion, and leave us completely satisfied at the end or hungry for more.
Now take those same skills and apply them to bankers, investors, fundamental and technical analysts and all of those who work in the world of finance and you can see the same correlation. Those who manage money like Financial Advisors use formulas and ratios to tell the story of the past, the present, and the future of companies, bonds and other investments. Lenders (banks and credit unions) use income ratios, net worth, collateral ratios, credit scores and other factors to gauge the repayment ability of prospective borrowers.
One such ratio is, Debt-to-Income. This is used by Fannie Mae (FNMA) and Freddie Mac (FHLMC) secondary mortgage lenders or any company in the business of loaning funds to finance auto loans, credit cards, agricultural lending. Very simply put, it’s the total amount of contractual monthly payments divided by the amount of “gross” monthly income.
Here’s an example:
Fred made an offer on a home through a local realtor. He has saved $20,000 as a down payment. He desires the lowest, fixed interest rate possible. The mortgage broker at the bank explains the process of applying for the loan. One factor is that all fixed rate loans at the bank will be sold to Freddie Mac and therefore he must qualify under their guidelines for debt-to-income which is set at 36% ( Proposed mortgage payments will be calculated to include principal, interest, taxes and hazard insurance).
- Fred earns $65,000 per year, $5,417 monthly, managing the local grocery store.
- His car loan payment is $526.00.
- He has no other debt.
- The home he is interested in is listed for $185,000. His offer of $181,000 was accepted.
- The Treasurer’s office lists real estate taxes at $1,475 yearly which comes out to $123/month.
- Hazard insurance has been estimated at $975 yearly (monthly $81.25).
| Loan Information: | |
| Purchase price | $181,000 |
| Down payment | $20,000 |
| Amount to finance | $161,000 |
| Loan terms: | |
| Amount to Finance | $161,000 |
| 15 year mortgage @ | |
| 3.75% interest rate = | Payments of principal and interest = $1,170.83 |
| Add in; | |
| Real Estate Taxes | $123.00 |
| Hazard Insurance | $81.25 |
| Total Mortgage monthly debt | $1,375.08 |
| Debt-to-Income Calculation: | |
| Add in car loan payment of $526.00 | $526.00 |
| Total monthly debt | $1,901.08 |
| $1,901.08/$5,417 = | 35.09% debt-to-income |
Based solely on the Debt-to-Income ratio, Fred COULD qualify for the loan, but consider that every month after both house and car payments are made, Fred only has 65% of his gross earned income left to pay his Federal, State, County, City taxes as well as Social Security and Medicare obligations. Also, he will need to purchase food, clothing, utilities, car insurance, life insurance, etc. Don’t forget, one of the most important things, saving for his future retirement. At 35.09% Fred is pushing the envelope. He might consider a lower priced home or he could stretch out his payments to 30 years, while fifteen years of extra interest is not ideal.
When it comes to investing, the amount you are disciplined to commit and the number of years you make this commitment, the better your odds are of attaining the levels of income needed to provide for a sound and enjoyable retirement. If you focus on that goal and keep a lower debt-to-income ratio throughout your life, especially when starting your career, it will be less difficult to reach.
I am not saying that having a mortgage or any kind of debt is wrong. I am saying that by being careful with credit, and the amount you use the ending to your story can be the one YOU choose.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer.
