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For a serious home buyer, this is a most fundamental question:
How much mortgage can you afford?
Generally, most prospective homebuyers can afford a mortgage that costs between 2 to 2.5 times of their gross income. Using this rule, a person who earns $100,000 per year can afford to borrow $200,000 to $250,000. But this is just a basic guideline – if you want a more definite figure, you have to consider many things.
Or, try to look at it this way. Put together the current interest rates plus strict underwriting rules plus the down payment you can come up with, then your income, debt and credit scores. Taking all of that, how much mortgage would a lender be willing to approve for you?
Calculator is good, but not perfect
Many prospective homebuyers try to do a shortcut by using an online mortgage calculator. Plugging in your monthly income, expenses and what you think your credit score is would get you an amount. But it may not be exactly what an actual lender would lend to you (See how to find the best mortgage lender). You will also miss out on the insights you can get with an actual evaluation of your case. There are a lot of flexible, case-to-case factors that many lenders use in the approval process.
Eventually, when buying a property, there are still many more factors you should consider.
First, it’s good to understand what your lender thinks you can afford and how they computed for that amount. Next, you need to find the non-financial criteria for evaluating your account such as your preferences and priorities.
What Is The Maximum Amount I Can Borrow?
Each bank would usually have its own criteria for lending and many of them consider many things. So, the amount and terms of the loan they can give a borrower would depend on different factors.
Here is an overview of what most of them look for so you can quite accurately predict whether you qualify for a loan or not and the forecast the amount you’ll be able to borrow:
Gross income is that income a person makes before he or she pays income taxes.
It is made up of the total salary plus bonuses, any part-time income or self-employed earnings, Social Security benefits, alimony and child support. The gross income is integral in the determination of the next item.
The front-end ratio is the percentage of the monthly gross income that you can earmark to pay your mortgage every month.
A mortgage payment has four components (commonly known as PITI) or specifically: principal, interest, taxes and insurance.
What about the PMI?
The insurance part actually refers to your property insurance and private mortgage insurance (PMI). A basic rule to follow is that the PITI should not exceed 28% of the gross income.
However, many lenders allow borrowers to exceed 30% and a few of them even go as high as 40% (See how to avoid paying mortgage insurance).
Also called the debt-to-income ratio (DTI), it measures the percentage of your gross income that is required to cover your debts. Debts would include credit cards, loans (auto, student, etc.), child support, etc.
For example, if you make $5,000 a month but pay off $2,500 each month for your outstanding debts, your ratio is 50%. This means that half of your monthly income goes to debt repayment.
The bad news is, a 50% debt-to-income ratio is probably not going to make your dream home a reality. Most lenders would like to see a debt-to-income ratio of not more than 36% of your gross income.
Here is a simple formula to calculate your maximum monthly debt based on this ratio. Just multiply your gross income by 0.36 and then divide it by 12. So, if you earn $100,000 a year, then your monthly debt payment should not exceed $3,000. The lower your DTI, the higher your chance for loan to be approved.
If the head side of the affordability coin is income, the tail side is risk.
Most lenders have their own formula to determine the risk level of each prospective homebuyer. The formulas tend to vary among lenders but all of them would likely make use of the borrower’s credit score (See how to calculate your credit score).
The lower an applicant’s credit score is, the higher the interest he would most likely pay. Lenders also call this as the Annual Percentage Rate (APR) on a loan.
One helpful advice:
As you think of the kind of house you want in the future, work on your credit score now. And monitor your credit reports too. If there happens to be erroneous entries, it may take time to correct them. You don’t want lenders to disqualify you for your dream house because of something that’s no fault of yours. Here’s another thing that can offset negative entries in your credit report: it has to do with…
The down payment is the upfront amount that a homebuyer pays for the residence, in cash or other liquid assets.
If the homebuyer is purchasing a $100,000 home and can afford a down payment of 10%, he must put up $10,000. The lender will finance the remaining $90,000. Lenders will typically ask for a 20% down (this will exempt buyers from the private mortgage insurance) but some will settle for a lower down payment.
However, the more you can put down, the less financing you’ll need and you’ll paint a better credit image to the bank.
Do not forget to include the closing costs in your computations. It can be anywhere from 2 to 5 percent of the total purchase price depending on the location.
The good news:
Fannie Mae and Freddie Mac allow the builder or seller to shoulder up to 3 percent of the house price to lower your closing cost. For FHA, it’s even higher at 3 to 6 percent.
Aside from the amount of the loan, the lender would also want to see how long would be the repayment term. Although a short-term mortgage may require a higher monthly payment, it may be less expensive overall.
Types Of Mortgages:
For many new buyers, the type of mortgage they choose will significantly affect their budget. There are four major types of mortgages:
- Conventional. These are loans intended for sale to Fannie Mae or Freddie Mac, the giant mortgage investment companies. These loans usually require higher down payments and a more stringent underwriting standard than government agency-backed mortgages.
- The Federal Housing Administration-insured loans are really for first-time buyers and those with less-than-perfect credit histories.
- VA. These are loans provided by the U.S. Department of Veterans Affairs, mainly for military personnel in active duty. Retired military personnel can also avail.
- USDA. This is also called a Rural Development Loan. It serves homebuyers in rural and small towns where credit facilities may be scarce.
FHA loans allow a minimum down payment of 3.5% for applicants with FICO credit scores above 580. If the score is below 580, they will require a 10% minimum down payment. FHA rules are softer than the rules of conventional lenders like Fannie Mae and Freddie Mac. Sometimes, they will allow a 50% DTI or even higher if there are other compensating factors. Among them are having a lengthy stable employment record, a high credit score, some savings in the bank or other owned assets.
On the downside, FHA has materially raised its mortgage insurance fees so it may be more expensive than conventional loans month-on-month. This is assuming you have ready cash for a higher down payment.
For the qualified homebuyer, the VA and USDA loans offer the biggest loan with the lowest down payment. Down payment may be as low as zero and the underwriting guidelines are much easier to comply with, especially with the VA loan.
The Automated Underwriting
What most homebuyers are unaware of is that the success of their mortgage applications rests with two national computers. These computers flash tens of thousand of “yes”, “no” or “maybe” answers to lender inquiries daily. The first one is Loan Prospector (LP), which Freddie Mac owns and operates. The other is Desktop Underwriter (DU), which Fannie Mae runs.
When put together, these two giant agencies supply majority of the mortgage money in the U.S. Practically all banks use their online underwriting programs to make preliminary assessments of the feasibility of mortgage applications. This also includes loans intended for insurance backing by FHA, VA or USDA.
How It Works
Your loan officer feeds your basic information into an LP or a DU. The underwriting software uses advanced statistical algorithms to determine if the proposed package deserves an approval or a rejection. It will take into consideration the credit reports, scores, income, assets, reserves, loan vs. property value, debt ratio, past mortgage vs. current application.
Automated underwriting actually increases your ability to acquire a home because it highlights bright spots in the application. These bright spots can counteract or outweigh the negative items in your application. For this reason, the underwriting process becomes more flexible than the customary strict set of rules. This explains why they sometimes approve a 45% to 50% DTI even though Fannie Mae says 41% is maximum.
Veteran loan officers have a way of getting your application approved through the DU or LP by adjusting the application “mix”. They can raise your credit score by asking you to reclassify some debt balances or finding ways to increase your eligible income.
One note of warning: Do not commit to a loan that will strain your monthly budget. This got many borrowers into trouble during the housing burst of 2007-2009.
Now you have an idea how the lender can determine how much mortgage you can afford. While having that amount is useful, do not exceed it. It is a good practice to apply your own standards. Just because a bank says you can borrow this much does it mean you should automatically borrow the maximum.
You are responsible for your own income and debt so use some common sense. For example, you may be thinking of your children’s college education or wedding in the future. The underwriting computers will not consider them in their computations but you should factor that on your own worksheet.