Understanding how much you can afford is one of the most important rules of home buying. Depending on your individual situation, your budget can affect everything from the neighborhoods where you look, to the size of the house, and even what type of financing you choose.
Bear in mind, however, that lenders will look at more than just your income to determine the size of the loan. Likewise, you may find that there are some creative financing options that can help boost your purchasing power.
Loan Prequalification vs. Preapproval
One of the best ways to determine your budget is to have your real estate agent or lender prequalify you for a loan. Prequalification is different from preapproval, because it is only an estimate of what you'll be able to afford. On the other hand, preapproval is a more formal process where a lender examines your finances and agrees in advance to loan you money up to a specified amount.
What Factors Are Important To Lenders?
Banks and lending institutions will use several criteria to determine how much money they'll agree to lend. These include:
Two Important Ratios
Lenders also use your financial information to figure out two, very important ratios: the debt-to-income ratio and the housing expense ratio.
Down Payments Make A Difference
If you can make a large down payment, lenders may be more lenient with their qualifying ratios. For example, a person with a 20 percent down payment may be qualified with the 33 percent housing expense ratio, while someone with a 5 percent down payment is held to the stricter 28 percent ratio.
Other Ways To Improve Your Purchasing Power:
Bear in mind, however, that lenders will look at more than just your income to determine the size of the loan. Likewise, you may find that there are some creative financing options that can help boost your purchasing power.
Loan Prequalification vs. Preapproval
One of the best ways to determine your budget is to have your real estate agent or lender prequalify you for a loan. Prequalification is different from preapproval, because it is only an estimate of what you'll be able to afford. On the other hand, preapproval is a more formal process where a lender examines your finances and agrees in advance to loan you money up to a specified amount.
What Factors Are Important To Lenders?
Banks and lending institutions will use several criteria to determine how much money they'll agree to lend. These include:
- Your gross monthly income
- Your credit history
- The amount of your outstanding debts
- Your savings--or the amount of money you have available for a down payment and closing costs
- Your choice of mortgage (i.e. 30-year, FHA, etc.)
- Current interest rates
Two Important Ratios
Lenders also use your financial information to figure out two, very important ratios: the debt-to-income ratio and the housing expense ratio.
- Debt-to-Income Ratio
Many lenders use a rule of thumb that the amount of debt you are paying on each month (car payment, student loan, credit card, etc,) shouldn't exceed more than 36 percent of your gross monthly income. FHA loans are slightly more lenient. - Housing Expense Ratio
It is generally difficult to obtain a loan if the mortgage payment will be more than 28 to 33 percent of your gross monthly income. All of the expenses that make up your monthly mortgage payment are also known as the PITI:- Principal: This is the part of the payment that goes towards paying down the amount you borrowed to purchase the house.
- Interest: This is the rate creditors charge for lending you the principal.
- Taxes: This is your property tax.
- Insurance: This is your homeowner’s insurance.
When you take the amount you owe towards your PITI and compare it to your income, you have your “front-end ratio.” This number is what most lenders look at when determining how much they’ll lend to you.
Dollar amount of your PITI ÷ Dollar amount of your gross monthly income = Front-end ratio
And then:
Front-end ratio x 100 = Front-end ratio percentage
With the 28/36 rule, you’ll want your PITI number to be less than 28% of your gross monthly income. Use this formula to find out exactly how much house you can afford. For example, if your gross monthly income amounts to $4,000 / month, the best mortgage you’re likely to attain would amount to no more than $1,120 / month since that’s 28% of your income.
Like your front-end ratio, your debt-to-income ratio is also worth calculating if you plan on getting a home mortgage. Unlike your front-end ratio (which compares the amount you owe on your house to your income), this number compares your income to your debt. Creditors look at this number to determine how risky it is to lend to you.The riskier it is to lend to you, the smaller chance you have of attaining a home loan — or at least a home loan with a good interest rate. Much like your debt-to-asset ratio, calculating it is simple:
Dollar amount of monthly debt you owe ÷ Dollar amount of your gross monthly income = Debt-to-income ratio
And then:
Debt-to-income ratio x 100 = Debt-to-income ratio percentage
Say you owe about $1,000 in debt month-to-month and make $75,000 a year ($6,250/month). We’d then take 1,000 divided by 6,250 in order to get our debt-to-income ratio, like so:
1,000 ÷ 6,250 = .16
Multiply .16 by 100 and you have 16% for your debt to income ratio … but what does that number mean? The lower the number is, the better. While the 28/36 rule-of-thumb says that you should ideally have no more than 36% for your debt-to-income ratio, most lenders will provide you a mortgage up to 49%. So if your debt-to-income ratio amounted to 16% like in the example above, you’d be in good shape for a loan.
If all this sounds a little overwhelming, then good. It should be. This is likely the biggest purchasing decision of your life. That’s why you need to research as much as you can before you dive in. The bottom line: The best way to qualify for a mortgage is to follow the basics of good personal finance: Save more, spend less, and pay off your consumer debt before applying. People who do these three things should sail through the underwriting process and get a mortgage on affordable terms.
Down Payments Make A Difference
If you can make a large down payment, lenders may be more lenient with their qualifying ratios. For example, a person with a 20 percent down payment may be qualified with the 33 percent housing expense ratio, while someone with a 5 percent down payment is held to the stricter 28 percent ratio.
Other Ways To Improve Your Purchasing Power:
- Gifts
If you're having trouble saving money, many lenders will allow you to use gift funds for the down payment and closing costs. However, most lenders require a "gift letter" stating the gift doesn't have to be repaid, and will also require you to pay at least a portion of the down payment with your own cash. - Negotiating Closing Costs
Through negotiation, some sellers may agree to pay all or most of your closing costs (for example, if you agree to meet their full asking price). If you choose to try this, make sure to ask your real estate agent for advice. - Loan Programs
Many local governments have special loan programs designed to help first-time homebuyers. Loans may be available at reduced interest rates, or with little or no down payments. Check with your local housing authority for more information. - Loan Types
Some homebuyers choose Adjustable Rate Mortgages (ARMs) because of low initial interest rates. Others opt for 30-year loans because they have lower monthly payments than 15-year loans. There are significant differences between different loans, so make sure to discuss the pros and cons of different loans with your agent or lender before making a decision.
