Determining What You – And Your Lender – Feel You Can Borrow
For anyone thinking about purchasing a home, it’s the most fundamental question: How much mortgage can you afford?
Put another way, with today’s interest rates, tough underwriting rules and the down payment cash that you can put together, what mortgage amount might a lender approve you for, given your income, debts and credit scores?
Many home shoppers opt for a “quick fix” answer by visiting websites that provide an online calculator. That’s fine, except that simply entering your monthly income, expenses and what you believe to be your credit score in a computer program won’t accurately predict what a specific lender will actually agree to lend you. More important, it won’t give you insights into the often flexible, case-by-case factors that lenders can use to get your loan application approved.
Here’s an overview of what really matters to lenders and how you can more accurately predict whether you’ll qualify for a given loan amount or not.
Mortgage Secret #1: Ratios Are Hugely Important
Every mortgage lender uses debt-to-income (DTI) ratios to arrive at a baseline judgment about your financial capacity to repay a loan. The idea is to measure your gross monthly household income and compare it to two types of debt:
- The money you spend each month on core housing-related expenses combined;
- And the amount you spend on non-housing debts, such as credit cards, auto loans, student loans, etc.
If you need to devote too high a percentage of your monthly income to pay off debts, then you may not have enough left over for food, clothing, transportation and other essentials. To a mortgage lender, that means (statistically, at least) that a buyer will likely fall behind on mortgage payments.
For example, say your monthly gross income before taxes and other deductions is $6,000. If your monthly payments for housing-related and other debt total $3,000 — an overall DTI ratio of 50 percent — most lenders will tell you that you need to lower that ratio significantly. To calculate your debt to income, lenders typically focus on these two specific ratios:
Your Housing Ratio:
How much will your key housing-related expenses total per month and what percentage of your income will they represent?
Your key housing costs include:
- Principal, interest, property taxes and hazard insurance on the loan you’re applying for;
- Homeowners association, condominium or cooperative fees that you are required to pay;
- Any additional fees required for your mortgage or property, such as flood insurance or mortgage insurance premiums.
Say your housing costs are projected to come to about $1,800 a month and you and your spouse, partner or co-owner earn a combined gross income of $6,000 a month. That’s a housing ratio of 30 percent ($1,800/$6,000). Most lenders will consider that (and even slightly higher) as acceptable, provided your total debts are not too high.
Your Total Debt Ratio:
Of the two ratios, this is the more important. A lender will take your total housing expense and add all other recurring debt payments that you have, including credit cards, auto loans or leases, personal installment loans, student loans, child support and alimony payments.
Take the $6,000 gross income example above. If your total debt payments come to $2,460 a month, your DTI is 41 percent. That should be acceptable to most lenders. Debt payments of $2,700 would take your total debt ratio to 45 percent and probably make you borderline for many lenders. At 50 percent or higher, most buyers would be turned down for a conventional Fannie-Freddie loan, but some might qualify for an FHA insured-backed mortgage.
Mortgage Secret #2: Loan Types Matter a Lot
For most new buyers, the type of mortgage they choose will greatly affect what they can afford. Keep in mind that there are four major types of mortgages:
- Conventional: loans intended to be sold to Fannie Mae or Freddie Mac, the giant mortgage investment companies. These loans generally require higher down payments and stricter underwriting standards than government agency-backed loans.
- FHA: Federal Housing Administration-insured loans are designed for first-time buyers and those with less-than-perfect credit histories.
- VA: Provided by the U.S. Department of Veteran Affairs, these guaranteed mortgages are reserved for active duty and retired military personnel.
- USDA: Also called a Rural Development Loan, these mortgages are intended to serve buyers in rural and small towns, where credit availability can be tight.
FHA loans require a minimum down payment of just 3.5 percent for applicants with FICO credit scores above 580. (Below that, 10 percent down is mandatory.) FHA underwriting guidelines also are more generous than conventional Fannie Mae and Freddie Mac rules and will often allow 50 percent DTIs or even slightly higher if you’ve got strong “compensating factors,” like a lengthy stable employment history, high credit score, savings accounts and other assets. However, FHA has recently raised its mortgage insurance fees significantly and may be more expensive on a monthly basis than conventional options if you’ve got plenty of cash to apply towards a down payment.
For those who qualify, VA and USDA loans can get you into the biggest loan for the least. Down payments can be as low as zero, and underwriting guidelines can be super-generous, especially if you qualify for a VA loan.
The Biggest Mortgage Secret: Automated Underwriting
Though most home buyers are unaware, the success of their mortgage applications — and thus their ability to buy a home — rests with two national online computer models that flash tens of thousands of “yes,” “no” or “maybe” responses to lender inquiries every day. One model is called Loan Prospector (LP) and is owned and operated by Freddie Mac; the other is Desktop Underwriter (DU) and is run by Fannie Mae.
Combined, these two giant agencies supply the bulk of mortgage money in the U.S. And their online underwriting programs are used by virtually all banks and loan officers to make initial assessments of the viability of mortgage applications, even if the loans are intended for insurance backing by FHA, VA or USDA.
This is how it works: Loan officers feed your basic information into an LP or DU. The underwriting engines use complex statistical algorithms to determine whether the total package — borrower credit reports, scores, income, assets, reserves, the amount of the proposed loan compared with the property valuation, debt ratios, types of debt the borrower has used in the past and the type of mortgage now being sought — deserves an approval for funding or not.
Automated underwriting can also increase your ability to buy a home because it searches for bright spots in your application that could counteract or outweigh negatives. It makes underwriting more flexible than a set of rigid rules. It’s the reason why a 45 or 50 percent DTI can get approved, even though the standard “rule” in Fannie Mae’s guidelines says 41 percent is the max.
Skilled loan officers can get your application approved through the DU or LP by adjusting the application “mix,” such as raising your credit score by having you move balances on certain debts or finding ways to raise your eligible income. One note of caution: Don’t allow yourself to commit to a loan amount that will strain your monthly budget. That was what got so many borrowers into trouble during the housing bust of 2007-2009.
Other key points
Your eligible “income” may be more than what you think. It’s not just what’s on your W-2s. Say you make a little extra money from a side business or receive additional income via rents, royalties, regular investment income or capital gains, alimony or child support payments, an automobile allowance from your employer, or rent from boarders. These types of additional revenue are all potentially includable to boost your loan amount, provided that you can document them and they are stable and continuing. For older applicants, Fannie and Freddie both allow the use of Social Security income, regular income from IRAs, 401(k) plans, SEPs and Keogh retirement accounts under certain circumstances.
Credit scores can be killers. Some lenders won’t approve applicants whose credit scores are below 640, 660 or even 680. If they do accept such scores, some lenders may hit homebuyers with heavy extra fees, even though they know the LP and DU will accept lower credit scores with compensating factors. Remember: there are dozens of credit score products on the market, but the only one that counts in automated underwriting is FICO. If your credit report was produced by any source other than FICO — even if it carried heavily promoted names like Experian, Trans Union, Equifax or FreeCreditScore.com — it’s not a FICO unless it says so and therefore won’t count.
Don’t forget to factor closing costs into any calculations you make. Depending on where the property is located, it can account for anywhere from 2 to 5 percent of the total home purchase transaction. The good news is that Fannie Mae and Freddie Mac allow your builder or seller to pay up to 3 percent of the house price to lower your closing costs. FHA allows anywhere from 3 to 6 percent.
Now you know how much home a mortgage lender thinks you can afford. While that number is useful, and you should not try to exceed it, it also makes sense for you to apply your own standards. Just because a bank says you can qualify for a given amount does not mean you should automatically borrow that full amount.
As the owner of both your income and debt, you can and should factor in your own thoughts. For example, perhaps you have a college education or a wedding to fund in the future for a child. While the underwriting processes described above won’t reflect such future expenses, you can and should consider them, as well.
With the advice above in mind, you should be better equipped to research and ultimately to decide what mortgage payment that you — and you lender — feel you can afford each month.
Kenneth Harney is a nationally syndicated columnist on real estate for the Washington Post Writers Group. His column, the “Nation’s Housing,” appears in cities across the country and has received numerous professional awards, including multiple Best Column-All Media awards from the National Association of Real Estate Editors and the Consumer Federation of America’s Consumer Media Service Award for “invaluable and unique contributions to the advancement of consumer housing interests.”