One of the first questions people ask themselves when looking to buy a home is: How much can I afford? If you are considering buying a home, it basically comes down to how much you have in cash, for a down payment, and how much you can borrow. How much you can borrow is really how much a lender will approve you for based off of your income, other debts, and credit score. In this article, we will share some of the ways in which a mortgage lender predicts how much home you can afford.
Important Ratios to Know About:
Debt-to-Income (DTI) Ratio
The DTI ratio is one of the ways through which lenders determine a your financial capacity to pay a loan back. The DTI ratio is used to measure your gross monthly income in relation to two different types of debts:
- The amount of money spent on primary housing-related expenses.
- The amount of money spent on debts unrelated to housing such as credit cards, student loans, etc.
If you are paying a higher percentage of your total income on debt, then you won’t be left with enough to spend on food, clothing, transportation and other such expenses. From the view of a lender, this scenario statistically means that the buyer will fall behind in paying back the loan.
Your Housing Ratio
What percent of your gross income will be used for key housing-related expenses in a given month? Your housing costs usually include the following:
- Interest, property taxes, principle, and the insurance on the loan for which you are applying.
- Condominium or cooperative homeowner association fees that you may have to pay.
- Additional fees that may be required for your loan or property, such as flood insurance.
As an example, suppose that the total housing cost is approximately $1,800 a month and the income that you and your spouse, earns in a month equals a combined gross income of $6,000. This accumulates a housing ratio of 30%. This ratio or a little higher is typically considered acceptable by most lenders, providing your total debts aren’t too high.
Your Total Debt Ratio
Of the two other ratios, this is the most important. A lender will accumulate your total housing expenses and all the other recurring debt payments that you may have accrued such as credit cards, student loans, personal installment loans, alimony support, etc.
If you consider the same example as mentioned above where your monthly income is $6,000, but your total debt is $2,460 per month, then the total DTI is 41%. This percentage is acceptable by most of the lenders. However, a debt of $2,700 will take your debt ratio to 45%, where approval becomes questionable with many lenders. At 50% or above, many of the buyers are rejected as the loan is considered high risk.
Loan Type Matters:
Lenders will also take into consideration the type of loan you will be need when determining the amount you can afford for your mortgage. There are four major types of loans:
Conventional: This loan is intended to be sold to Fannie Mae or Freddie Mac, two of the huge mortgage companies. These loans may require a larger down payment and often have stricter underwriting standards.
Federal Housing Administration: These loans, also known as FHA loans, are insured specifically for the first-time buyers, or for customers with a limited credit history.
VA: Deployed by the U.S. Department of Veteran Affairs, these loans are provided to the on-duty and retired military personnel.
USDA: This loan is also referred to as a Rural Development Loan. These are the loans made available to the people in rural and small towns where the availability of credit is tight.
An FHA loan does not require a large sum as a down payment; all it requires is 3.5% of the loan payment from the applicant who has a FICO credit score that is above 580. FHA’s underwriting guidelines are also very flexible and often allow a 50% DTI or even a higher percentage if you hold a strong compensating factor. However, FHA loan insurance fees have increased over the years, and it may be more expensive than conventional options.
Those who qualify for VA and USDA loans qualify for the largest loans. The down payments are and can often be as low as zero. The underwriting can also be very generous, especially in the case of a VA loan. When looking at buying a home, you do not need to know exactly which type of loan you want or need, a knowledgable mortgage lender will be able to help you determine the best loan type for your specific sitution.
Other Key Factors:
Income: If you are making a little extra money from a side business or receiving extra income through rents, royalties, etc., then these kinds of increased revenues can help in boosting your loan amount provided they are documented, and they are consistent and continuing.
Credit Scores: Credit scores are the most important factor in your loan application. Some lenders may not approve your loan if your credit score is below 640. If by chance they are accepting such scores, then some lenders may require the home buyer to pay an extra heavy fee.
Closing Costs: Don’t forget to consider closing costs in any calculations you make. Depending upon the location of the property, closing costs can be in the range of two to five percent of the total transaction.
This article helps you understand how much home you can afford by introducing you to several key ratios and information used by lenders. Understanding the ratios and limits described within this article can help you make sense of your own financial situation.