- The debt-to-income ratio measures what percentage of your pre-tax monthly income goes to debt such as credit card bills, student loans, car loans and your monthly housing payment -- including insurance and property taxes. The figure is important because lenders assume the higher the ratio, the harder time you'll have making ends meet, which makes loaning you money more of a risk.
- Lenders prefer to see a debt-to-income ratio no higher than 36 percent, advises the Lending Tree website, and they might not accept your application if your ratio comes out any higher. If you have Federal Housing Administration mortgage insurance, however, the ratio can be as high as 41 percent. Some sub-prime lenders will go as high as 50 percent, but you'll pay a price in the form of steep interest rates and unfavorable terms.
- Refinancing to a lower interest rate will usually result in a lower monthly payment, according to the Federal Reserve, and will lower your debt-to-income ratio. Sometimes, however, refinancing may increase your payment and your ratio. For example, you refinance to a shorter-term mortgage, which costs less overall, but requires higher monthly payments. Another instance is if you switch from an adjustable-rate mortgage to a higher fixed-rate because you expect the adjustable rate to rise much higher. Or you take a "cash out" refinance for more money than you owe on the mortgage.
- Even if the debt-to-income ratio looks good, there may be good reasons not to refinance. If you're close to the end of your original mortgage, for instance, refinancing means many more years before you pay it off completely. If you plan to move within a couple of years, it's possible the lower monthly payments won't wipe out the costs of taking out a new loan. Crunch the numbers to find the "break even" point before going ahead with the loan.
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