Understanding Debt in its Various Forms
Debt comes in many forms. In short, it’s the idea of enjoying a benefit now, while working for it later. Right off the bat, the most obvious risk with any debt is the ability to work it off at a later date. The largest asset that anyone possesses is not necessarily anything tangible. It’s the ability to work or produce. When this goes away, so does any chance of being productive. No one knows the future. This is why lenders put a price on the risk they take.
However, not all debt is created the same. Certain debts can come with tax advantages. Take student and home loans, for example. Certain deductions can be made on the interest collected on these loans. Tax advantages aside, they’re still debts and anchors on potential income.
Consumer debt is a different beast. Credit cards come with crippling interest that is not tax-deductible. Dealerships are also happy to finance the purchase of that shiny, brand new automobile on credit, perhaps even stretching the customer’s limits to help close the deal. Most retail locations operate in a similar fashion.
Debt-To-Income Ratio for Homebuyers
Lenders use an objective process to measure the ability of a borrower to repay mortgage payments on a monthly basis. This is what’s known as a debt-to-income ratio (DTI). Simply take all monthly debt payments and divide by gross monthly income. This number is expressed as a percentage.
Obviously, a borrower and lender would prefer a low DTI as this means there is a good balance between debts and income. Conversely, a high DTI means this a healthy balance does not exist between the two. 43% is the typical ceiling for a borrower to be qualified for a loan. The lower the number, the better chance to be get qualified.
Lowering the DTI is crucial for potential homebuyers. Borrowers looking to reduce this number can do one of two things. First, they can increase their gross income. If the debt remains the same, the number will decrease – unless the spending increases as well. Second, the number can be reduced by lowering the debt. Borrowers can attack the debt, so to speak, thereby reducing the DTI in the process.
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