The mortgage debt ratio is used by mortgage lenders to see if potential home buyers have the ability to make monthly mortgage payments. This ratio is calculated by taking the monthly income earned by a borrower and dividing it into the projected monthly mortgage payment. A more stringent form of mortgage debt ratio also takes into account the debt already owed by a borrower each month and adds that to the mortgage payment. Mortgage lenders generally require a specific ratio be maintained by borrowers before they consider granting a mortgage.
Most potential home buyers lack the cash to buy homes without some sort of financial help. This help generally comes in the form of a mortgage, in which a bank or other certified mortgage lender provides a loan to allow the borrower to buy a house. The borrower must provide a small down payment, and then pays back the loan, along with interest at a predetermined rate, in monthly installments. Since a mortgage lender is at risk of losing its investment should the borrower default on his mortgage, a mortgage debt ratio can be used to determine the financial standing of the borrower.
As an example of a mortgage debt ratio, imagine that a lender is scheduled to provide a mortgage that will cost the borrower $1,000 US Dollars (USD) in monthly mortgage payments. The borrower has a monthly income of $4,000 USD. This means that the ratio of mortgage payments to earnings, also known as the front ratio, is $1,000 USD divided by $4,000 USD, which comes to .25 or 25 percent.
Mortgage lenders will also want to know about other debt incurred by a borrower, since that will also affect his ability to pay back the loan. As a result, the back ratio is calculated by adding this extraneous debt to the amount owed on the mortgage. Using the example above, imagine that the borrower also had $500 USD in monthly debt from credit card payments. This would be added to the $1,000 USD mortgage payment for a total projected monthly debt of $1,500 USD. The $1,500 USD would then be divided by the $4,000 USD monthly income to yield a back ratio of .375, or 37.5 percent.
Although different mortgage lenders have different standards and can take other factors into account, they generally require a certain mortgage debt ratio before proceeding. For a front ratio, the percentage shouldn't get higher than 30 percent. Anything higher than a 40 percent back ratio would likely make lenders turn down a mortgage loan.