A perfect example of this phenomenon is a real-life situation of a divorcee. The borrower was a teacher who was recently divorced. She lived in a $280,000 home, and the mortgage was covered by her ex-husband. After the divorce, the teacher remained in the house, but she couldn’t afford the house payments. Within a few months, she found herself facing a foreclosure. She contacted a lender to try to refinance the home in order to keep the house. Unfortunately, her debt ratio was so “out-of-whack” that she wasn’t able to get a loan, even though her credit was perfect (the delinquent mortgage was on the ex-husband’s credit).

Your credit history has much to do with your debt ratio as well. If you have absolutely perfect credit, you might qualify for a no-income-verification loan. For this type of loan, the lender will use whatever income figure you supply. If you make $12,000 per month selling figurines on ebay, you can enter $12,000 for your income on your application, and the lender will not ask to verify it. The reasoning behind this is that if your credit is perfect and your scores are high, there is an inherent assumption that you know how to manage your money. Therefore, you know what you can afford. Usually, you will need a credit score of at least 700 to qualify.

You might ask, “What about the divorced teacher? She had perfect credit – couldn’t she have qualified for a no-income loan?” The answer is it depends on the lender. In most cases, no-income-verification loans apply to self-employed borrowers only. The teacher was not self-employed. Further, lenders apply a reasonability test. It would be unreasonable to expect a teacher to make a salary high enough to support a $280,000 house.

You don’t have to have perfect credit for a no-income-verification loan. Most subprime lenders will also offer a no-income-verification product. You can have a score as low as 580 and qualify for a no income loan. However, the interest rates and fees can be exorbitant for the subprime version of this product.

Before applying to a lender, analyze your own situation. Obtain a copy of your credit report from the three major credit bureaus so you can see what accounts the lender sees. If the account is not listed on the credit report, chances are it won’t count against your debt ratio. In any case, by analyzing your credit reports, you can calculate your own debt ratio, within a reasonable degree of accuracy. Add up all of your verifiable income for every borrower listed on your application. Then, add up all of the accounts showing up on all credit reports. Divide the debts by the income.

Your best bet, regardless of your debt ratio, is to make sure your credit scores are as high as possible. Whether you plan on taking advantage of a no-income-verification loan or not, when you have high credit scores, you have more options available to you. You will garner more leniency when it comes to debt ratios. Lenders will either grant you debt-ratio exceptions, or will lower your rate to fit a debt-ratio. Either way, you will get the best rates available when your credit scores are high. Lower rates give you a better chance of fitting into most debt-ratio guidelines.

What is a debt ratio? It is your total monthly debt divided by your total income. For example, if you pay $1,000 per month in bills and your income is $3,000 per month, your debt ratio is 1000/3000 or 33%. In other words, about one-third of your total income is taken up by monthly bills.

More goes into this equation, however. Lenders usually calculate your debt ratio using your gross monthly income. Some, though very few, will calculate debt ratio with net income. If they do use net income, they will usually take 75% of your gross income.

On the debt side of the equation, usually only debts that are reported on your credit report are counted against your debt ratio. That means, for example, your car insurance payments or your gym memberships aren’t taken into account. As well, many utility companies, such as electrical, gas, and water, will report your monthly payments on your credit report. However, utility bills and cell phone bills are usually not counted against debt ratio, even if they are on the credit report. In any case, debt ratio is not a good indication of your debt levels.

How does debt ratio affect your approvals? Lenders have different criteria for debt ratio. They might give a front end/back end ratio of 28/33. This ratio means that no more than 28% of your gross income can be allocated towards a mortgage payment. As well, your total debt load, including your credit cards, auto loans, and the new mortgage, cannot exceed 33%.

This ratio has several implications. First, the value of the house you can shop for cannot exceed a certain amount. Second, if you have a high debt load, it will limit your price range. Further, if you have an extremely high debt load, your debt ratio will not support any kind of price on a house. In other words, you’ll be denied no matter how good your credit if you have too much debt. This is the power of the debt ratio.

Debt ratio is not a good indicator of what you can or cannot afford. Debt ratio only applies to what the lender sees on paper. If you have a side business that generates a good amount of income, you might be able to afford a house in a higher price range. However, without the proper documentation, lenders cannot count your business income.

What can you do about debt ratio? You have a couple of options, but both point to manipulating your ratio in some way. First, you can pay down your debts. By paying down or eliminating some debts, you can improve your debt ratio and increase your buying price range. Obviously, the higher the payment you can knock out, the better for your debt ratio.

Here’s a trick you can use to better your chances. For most people, the highest payment on their credit report, outside of a house payment, is a car payment or other type of installment loan. Many lenders will not count an installment loan against your debt ratio IF there are less than 10 payments remaining. If there is any possible way for you to pay down your installment loan to fewer than 10 payments, your debt ratio will improve dramatically. For example, if you have a car loan that has 13 payments left, you don’t have to pay off the entire loan to enjoy the improved debt ratio. You simply need to pay 3 payments’ worth to get the balance down.

Three caveats to this trick. First, this only works if the lender utilizes the 10 payment rule. Second, this only applies for installment loans; that is, loans that have a fixed term and fixed monthly payment (car loans, student loans, and some personal loans). You cannot use this rule against credit cards and other revolving lines of credit. Third, most lenders will not apply this rule to a car lease, so even if you have less than 10 lease payments remaining, it will count against you. The lease payment rule is not industry-wide however, so check with the mortgage company.