You think you can afford a mortgage, but does the lender agree? How do you know what the lender thinks of your situation? Besides asking the lender flat out, you can learn the calculations lenders use. This gives you a good idea of what to expect when you apply for a mortgage.
Debt Ratios are the Most Important
If we had to pick one thing lenders look at the most, it’s your debt ratio. This is your liabilities versus your income. However, lenders may calculate your income differently than you. We discuss how below. For now, let’s look at debt ratios and how they stack up for loan approval.
- Conventional loans – 28% housing ratio and 36% total debt ratio
- FHA loans – 31% housing ratio and 43% total debt ratio
- VA loans – 41% total debt ratio
- USDA loans – 29% housing ratio and 41% total debt ratio
You can see how the ratios vary. Now let’s look at the differences between the two ratios.
Your housing ratio is your total gross income versus your housing payment. This includes your principal, interest, taxes, homeowner’s insurance, and mortgage insurance. For a conventional loan, you can’t pay more than 28% of your total income. For government-backed loans, you have a little more leeway, but not a ton.
Your total debt ratio takes your total housing payment plus any other monthly debts. You don’t have to include things like your utility payments or insurance premiums. Instead, include any installment loans and credit card payments. The total of these payments can exceed the total debt ratio as noted above.
Calculating your Gross Monthly Income
Here’s the tricky part. Your qualifying income is more than what you bring home. That’s your net income. Lenders use your income before taxes. For example, you make $80,000 per year. A lender then uses $6,667 per month for qualifying purposes. You obviously don’t bring that much home because you must pay taxes. But the lender uses it for your gross monthly income.
If you aren’t a salaried employee, the lender will use a different calculation. See below for a few examples:
- Hourly employees – The lender will use your total income from your W-2s for the last 2 years. They will take a 24-month average of this amount. This helps them account for the highs and lows your income experiences.
- Commission employees – Lenders also use your W-2s and/or tax returns for this situation. Commissions can go up and down. Using one or two months of income won’t provide an accurate picture. But, when a lender uses 2 years’ worth of income, it accounts for those differences.
Your Credit History Matters
Your credit history has a lot to do with what you can afford. It shows what debts you have outstanding. But, it also shows how well you pay your bills. Your credit score is an overall look at your financial responsibility. However, your credit history shows lenders exactly what you do. If you have 3 late payments, it shows you don’t pay your bills on time. In a lender’s eyes, you can’t afford a loan. If you don’t have any late payments, though, it paints a different picture.
The Size of Your Down Payment Determines What you can Afford
How much money you put down on the home also helps determine what you can afford. This directly ties into your debt ratio. The more money you put down, the lower your mortgage payment. This means a lower debt ratio. Of course, you shouldn’t put down more than you can afford to put down. For example, don’t deplete your reserves just to make your payment lower. This still shows the lender you are risky. If you don’t have an emergency fund to cover your bills in the event of a disaster, you could be in trouble.
A Big Puzzle
Literally, lenders look at each loan file like a big puzzle. They must put all of the pieces together. They start with your credit score. This is the first indication whether you can afford a loan or not. If your credit score doesn’t meet the lender’s requirements, they won’t waste their time on your file. If your credit score is high enough, they then look at other factors. This includes your income, assets, and debt ratio. They make sure your debt ratio is in line with their requirements. They also look at the stability of your employment. Lastly, they’ll look at the debts you have outstanding. They put each risk together to determine if you can afford a mortgage or not.
Helping Your Case
So what do you do if a lender says you can’t afford a mortgage? You have a few options:
- Find a less expensive home
- Put more money down on the home if you can afford it
- Wait until your income is more stable
- Wait until you have a larger emergency fund collected
Lastly, you can shop around with different lenders. Just because one lender says you can’t get a mortgage doesn’t mean another will say the same. Each lender has different parameters. They each must abide by the minimum requirements set by each program. However, they can add their own requirements too. For example, an FHA lender may not be willing to take an applicant with a debt ratio as high as 43%. They may want applicants with a DTI around 40%. That doesn’t mean a lender down the street thinks the same way.
The best thing to do is shop around. Get quotes from at least 3 different lenders. This way you know what is available to you. Then you can decide not only what they think you can afford, but what you want to pay each month. This allows you to avoid getting in over your head. Lenders use some pretty arbitrary numbers, but only you know what you truly want to pay each month. Stick to your budget and find the loan that is right for you!