The debt to equity ratio measures the amount of mortgage, or debt, to the total value or price of a home. Expressed as a percentage, this number often influences the terms you'll be offered for new mortgage loans. Typically, interest rate and terms, along with closing cost fees, are determined by debt to equity percentages. The lower the debt to equity ratio, the better the terms you'll often receive from mortgage lenders.
All lenders usually structure loan terms around at least two factors: First, the competition. Rates and terms must approximate those offered by the lender's competition. The second factor is perceived risk. All lending terms, for any financing, consider the projected risk of making a loan. Borrowers with higher credit scores represent reduced risk, generating lower interest rates and better terms. Debt to equity is an equally influential factor, as the lower the ratio, the less perceived risk, since the borrower has more equity to protect.
Most mortgage lenders want a debt to equity ratio of 80 percent or less. This ratio means that your mortgage equals 80 percent of the current value of the home, giving you a 20 percent equity, or ownership level. If you are buying a home, this means that you are putting 20 percent of the purchase price as a down payment. When refinancing, this level indicates that you have a 20 percent ownership in the property, so the lender is risking 80 percent of the home's value by making the mortgage loan.
When you have debt to equity ratios lower than a lender's maximum, you may get extra consideration for approval or more favorable loan terms. For example, a 60 percent debt to equity ratio translates to much lower risk for the lender than an 80 percent ratio. Since you own more of the property's value, the lender has less money at risk, should the lender need to foreclose. Debt to equity ratios often translate to easier, faster application approvals and, possibly, interest rate discounts.
Some mortgage programs, such as FHA-guaranteed loans, permit over 80 percent debt to equity ratios. Some, such as VA loans, may even allow debt to equity ratios up to 100 percent, meaning that the borrower has no equity in their home, with the lender assuming all of the risk. Borrowers usually must have private mortgage insurance, for Fannie Mae or Freddie Mac loans, when the debt to equity ratio exceeds 80 percent. Government loans, such as FHA, VA or Department of Agriculture guaranteed loans, must have mortgage insurance regardless of debt to equity ratios.
Real estate investors sometimes use a slightly different debt-to-equity calculation. They replace real estate value or selling price with equity level. Therefore, the calculation becomes the mortgage balance divided by the equity in the property. Someone borrowing $160,000 for a $200,000 home has $40,000 in equity. Dividing $160,000 by $40,000 gives this home a debt to equity number of 4. That same home with a $180,000 mortgage would have a debt to equity level of 9. The lower the number, as in the classic mortgage lender ratios, also reduces the perceived risk of default.