Your monthly mortgage

Step One - Calculating Your Monthly Income

When a loan officer prequalifies you, he works backwards to figure your maximum mortgage amount. You can do the same thing. The first step is to determine your monthly income. It isn't quite as easy as it sounds. Lenders only count income they can document through paperwork.

If you are a salaried employee, and don't earn bonuses, it's easy. Get out your paycheck. If you get paid twice a month, multiply by two. If you are paid every two weeks, then you multiply by 26 (the number of pay periods in a year) and divide by twelve. Unless you're a teacher. Teachers don't always work year round and they have special rules.

If you are an hourly employee who works a straight forty hours a week and don't earn overtime income, then it's easy, too. Look at your paycheck, multiply your hourly rate by 40, multiply that total by 52, then divide by twelve.

If you earn overtime, bonuses, or commissions -- it isn't as easy. Lenders don't give you credit for what you are currently earning. They average your income from those sources over the last two years, then add that to your regular salary or hourly monthly income. If you want a shortcut that is usually close, get out your W2 forms for the last two years. Add them together and divide by twenty-four. That is your monthly income.

If you are a teacher, a nurse, a seasonal employee, in construction, or earn only part-time income -- you can use that shortcut, too. Add the figures from your last two years W2's, then divide by 24. It generally gets you close.

If you are self-employed or receive 1099 income, then you need a two-year track record. Lenders go by what you declare to the IRS as income, since that is documentable. Since some self-employed people overstate their expenses, this may understate your income. Look at the Schedule C of your tax returns for the last two years and the number at the bottom that says "profit" is your annual income. You can add any depreciation to that figure. Add them together and divide by twenty-four.

There are variations and exceptions (like those who own their own corporations) but the above should cover most people.

Monthly Income to Consider

Total net or take-home pay

Child support or alimony payments received

1099 Income after taxes divided by 12

Other monthly income

Now add up debt and income and divide.

The above list is only a guideline for gathering personal information. It may include every possible aspect of your debt/income but you may need to add categories or not use some of the categories in your calculation. If you add lines to your debt calculation do not include bills for services or products unless you have placed such bills under a payment plan such as establishing a fixed payment plan with your dentist. Under income do not include windfalls such as one time gifts, an insurance settlement, an inheritance or lottery winnings.

So now you have made the calculation. How can we answer the question how much is too much? When applying for credit, the loan officer will look at your debt to income ratio as one factor in making a decision but it will not be the only factor considered. The same debt to income ratio may be great for one family but may have a negative impact on another. Debt to interest ratios in the end are a subjective tool for loan officers to make decisions about your ability to meet a new obligation. There are some general guidelines, however, that will give you a reasonably solid picture of where you stand in the eyes of a loan officer.

So now you have made the calculation. How can we answer the question how much is too much? When applying for credit, the loan officer will look at your debt to income ratio as one factor in making a decision but it will not be the only factor considered. The same debt to income ratio may be great for one family but may have a negative impact on another. Debt to interest ratios in the end are a subjective tool for loan officers to make decisions about your ability to meet a new obligation. There are some general guidelines, however, that will give you a reasonably solid picture of where you stand in the eyes of a loan officer.

20% or less is generally considered as an excellent ratio by the vast majority of loan officers

20% - 36% is a good ratio and will most likely not cause any problems with loan officers or have a negative impact on your FICO score

36% - 40% puts you on the edge of the limits of acceptability. Most lenders will ask for an explanation for why your debt to income ratio is so high. In addition, a debt to income ratio in this range begins to have a negative impact on your FICO score so lenders look to other strong numbers before making a decision to loan more money to you

40% or higher sends up red flags with lenders and your FICO score. Often, this high a ratio will be a deal killer with most lenders

By calculating your own debt to income ratio you begin to get a handle on your own financial situation. If the ratio is too high it tells you that you are too deep in debt and you must do something to reduce debt. Of course, if it is very low then you need do nothing. For most lenders and the impact of debt to income on your FICO score a positive reduction in the ratio is presumed to be a sign of a healthy financial condition and goes a long way in enhancing your credit history.