Debt Capacity
How much can you comfortably afford?
Living within your budget becomes much easier if you follow a few debt capacity rules. The easiest to calculate is the 28/36 rule.
28/36 RULE:
No more than 28% of your gross (before-tax) monthly income should be spent on housing expenses (including property taxes and insurance).
No more than 36% of your gross (before-tax) monthly income should be spent on consumer debt (car payment, credit card payments, student loan payments, etc.) and housing expenses (including property taxes and insurance.
DEBT PAYMENTS-TO-INCOME RATIO
This calculation uses the net (after-tax) monthly income. No more than 20% of your net income should be used on credit payments (excluding housing). Simply divide your monthly debt payments (student loans, credit cards, cars, etc) by net monthly income. And remember to exclude housing costs.
DEBT-TO-EQUITY RATIO
A lower debt-to-equity ratio is better, but as your ratio approaches one, you are reaching your upper limit on debt obligations. To calculate, divide your total liabilities (what you owe excluding mortgage) by your net worth (excluding the home value).
What do banks use?
Financial institutions will use a variety of factors to determine your loan eligibility. They will use the ratios identified on this page along with your credit report and the five C's of Credit (character, capacity, capital, collateral, conditions).
Remember, the financial institution may approve you for a loan that results in high debt payments and little discretionary income. When it comes to borrowing, LESS IS MORE!