For anyone thinking about buying a home, the fundamental question is: How much can you really afford the home?
Put another way, with current interest rates, harsh risk assessment rules, and the cash down payment you can collect, what mortgage amount should a lender approve you, given your income, debt, and creditworthiness?
Many homebuyers opt for a quick fix by visiting websites that provide the service of calculating the mortgage online. That’s fine, except that just by entering your monthly income, your expenses, and what you think is your creditworthiness into a software calculator, that won’t tell you exactly how much a specific lender will actually agree to lend you. And most importantly, it will not give you the usually flexible factors according to each lender, so that your mortgage loan application is approved.
Here’s a rundown of what lenders really care about and how they can more accurately predict whether or not they qualify for a given loan amount.
Mortgage Secret #1: Ratios are hugely important.
Each mortgage lender uses the debt-to-income ratio (DTI) to arrive at a benchmark for its financial capacity for mortgage repayment. The idea is to measure your gross monthly income and compare it to two types of debt:
- The money it allocates monthly to the main expenses related to housing combined;
- And the amount you spend on non-housing debt, such as credit cards, auto loans, student loans, etc.
If you need to set aside too high a percentage of your monthly income for debt repayment, then you might not have too much for food, clothing, transportation, and other essentials. For a mortgage lender, that means (statistically, at least) that a buyer is likely to fall behind on mortgage payments.
For example, let’s say your gross monthly income before taxes and other deductions is $6,000. And your monthly payments for housing-related issues and other debt reach $3,000 — a 50 percent DTI ratio — most lenders will tell you to lower this ratio significantly. To calculate your debt-to-income ratio, lenders typically focus on these two specific relationships:
Your relationship with housing:
How much will your major monthly housing-related expenses total and what percentage of your income will they represent?
Its main housing-related costs include:
- Principal, interest, property taxes and risk insurance on the mortgage you apply for;
- Expenses related to the homeowners, condominium or cooperative association to be paid;
- Any additional expenses required by your mortgage or property, such as flood insurance or mortgage insurance premiums.
Let’s say your projected housing expenses are around $1,800 per month and you and your wife, partner, or co-owner have a combined monthly gross monthly income of $6,000. This is a housing ratio of 30 percent ($1,800/$6,000). Most lenders will find it acceptable, as long as your total debts aren’t 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 up all other recurring debt payments you have, including credit cards, auto loans or rents, installment credits, student loans, child support, and alimony.
Take the example of the $6,000 of gross income above. If your total debt payments amount to $2,460 per month, your DTI is 41 percent. This would be acceptable to most lenders. Debt payments of $2,700 would bring your total debt ratio to 45 percent and this is likely to be on the limit for many lenders.
At 50 percent or more, most buyers would be rejected a conventional Fannie-Freddie mortgage loan, but some would qualify for a Federal Housing Administration (FHA) mortgage insurance loan.
Mortgage Secret #2: Mortgage types vary greatly.
For most new buyers, the type of mortgage they choose will greatly affect what they can acquire. Keep in mind that there are four main types of mortgages:
1. Conventional: Mortgages to sell to Fannie Mae or Freddie Mac, the giant mortgage investment companies. These mortgages generally require higher down payments and stricter risk assessment standards than government agency mortgages.
2. FHA: Federal Housing Administration loans are designed for first-time homebuyers and those with not-so-good credit history.
3. VA: Provided by the U.S. Department of Veteran Affairs, these secured mortgages are reserved for active military personnel as well as retired personnel.
4. USDA: Also called Rural Development Loan, these mortgages are for buyers in small and rural towns, where the availability of credit may be scarce.
FHA loans require a minimum down payment of only 3.5 percent for applicants with FICO credit ratings above 580. (Below that, a 10 percent down payment is required.) The FHA’s risk assessment standards are also more generous than the rules of conventional Fannie Mae and Freddie Mac and generally allow 50 percent DTI, and slightly higher if you have good “compensatory factors,” such as a long and stable employment history, a high credit rating, savings accounts and other assets. However, the FHA has recently raised its mortgage insurance rates significantly and they could be more expensive on a monthly basis than conventional options, if you have a lot of cash to apply for a down payment.
For those who qualify, VA and USDA loans can give you the most loan for less. Down payments can be as low as zero, and risk assessment standards can be very generous, especially if you qualify for a VA loan.
The biggest mortgage secret: automated risk assessment.
Although most homebuyers don’t know it, the success of their mortgage applications – and therefore their ability to buy a home – is in the hands of two national online models that quickly display tens of thousands of “yes,” “no” or “likely” answers to loan applications on a daily basis. One model is called a Loan Finder (LP) and is owned and operated by Freddie Mac; the other is called Risk Assessment (DU), and is executed by Fannie Mae. These two giant agencies combined provide the largest volume of mortgage money in the United States. And its online credit assessment programs are used by virtually all banks and loan officers to make estimated assessments of the viability of mortgage applications, even when the loans are insured by the FHA, VA or USDA.
Here’s how it works: loan officers enter their primary information into the LP or DU. The risk assessment machinery uses complex statistical algorithms to determine whether the entire package (loan applicant’s credit reports, qualifications, income, assets, reserves, the amount of the proposed loan compared to the property valuation, debt ratios, types of debt the applicant used in the past, and the type of mortgage now requested) deserves approval to be funded or not.
Automated risk assessment can also increase your ability to buy a home because it looks for positive points in your application that can counteract or weigh negative points. It makes risk assessment more flexible than a set of rigid rules in place. That’s why 45 to 50 percent DTI can be approved, even though the standard “rule” in Fannie Mae’s standards says 41 percent is the maximum.
Experienced loan officers can get your application approved through the DU or LP by adjusting the application “mix,” raising your credit rating by delaying balances on certain debts or looking for ways to raise your qualifying income. But attention: don’t commit to a loan amount that puts pressure on your monthly budget. This was what caused so much trouble for loan applicants during the housing crisis of 2007-2009.
Other key points
Income: Your qualified “income” may be higher than you think. It’s not just what’s on your W-2s paycheck and tax return. Let’s say you get a small additional income from a complementary activity or you receive an additional income through rent, royalties, regular income from investments or capital gains, child or alimony payments, an auto subsidy from your employer, Rentals.
These types of additional income have the potential to be included to increase your loan amount, as long as you can document them and that they are ongoing and stable. For senior applicants, Fannie and Freddie allow the use of Social Security income, regular IRA income, 401(k) plans, SEPs and Keogh retirement accounts under certain circumstances.
Creditworthiness: Credit scores can be eliminative. Certain lenders will not approve applicants whose credit scores are below 640, 660 or even 680. If they accept such ratings, certain lenders may charge homebuyers heavy expenses, even knowing that the LP and DU will accept lower credit ratings with compensatory factors. Remember: there are dozens of credit scoring products on the market, but the only one that counts in the automated risk assessment is FICO. If your credit report was produced by a source other than FICO — even if it carries highly hyped names like Experian, Trans Union, Equifax or FreeCreditScore.com — it’s not a FICO, unless you expressly say so and therefore won’t count.
Closing expenses: Don’t forget to include closing expenses in the calculations you make. Depending on where the property is located, it can vary from 2 to 5 percent of the total home purchase transaction. The good news is that Fannie Mae and Freddie Mac allow their builder or seller to pay up to 3 percent of the price of the home to lower their formalization expenses. FHA allows from 3 to 6 percent.
Summary: Now you know how much a mortgage lender believes you can afford to buy a home. While this amount is helpful to know, and you shouldn’t try to exceed it, it’s good for you to apply your own standards. Just because a bank says you qualify for a certain amount doesn’t mean you should automatically request the full amount.
As the owner of both your income and your debt, you can and should consider your own thoughts. For example, you probably have to fund a college education or a marriage for your children’s future. While the risk assessment processes described above will not reflect such future expenses, you can and should consider them as well.
With that advice in mind, you should be better equipped to research and ultimately decide what mortgage payment you — and your lender — think you can afford monthly.