Before you're able to get a mortgage the lender is going to run some quick ratios to determine if you can afford the home you want to buy. The lender wants to ensure you can pay your loan payment because they don't want bad debts on their books. It's not good for business.
The main areas that the lender, or bank, is going to look at are your credit score and history, your monthly income and the amount of money you'll be able to pull together for a down payment.
Credit score and history are fairly self-explanatory. The higher your credit score the better loan terms you'll likely receive. If you've paid your bills on time and don't have a lot of outstanding consumer debt chances are your credit is going to be in decent shape.
Down payments are a little trickier. Are you going to put 5% down or the traditional 20% down? Your decision will impact your ongoing monthly payments. Putting anything less than 20% down will trigger private mortgage insurance (PMI) that you will have to pay every month in addition to your regular principal and interest payments. This insurance protects the lender in the event that you default on your obligation. It can be expensive, in some cases being well over $100 per month.
For some reason people seem to spend a lot of time focusing on credit score and down payment. But one of the biggest factors is income. Straight up... Do you have enough income to afford the home you want?
There are two ratios you can run yourself to tell if you have a good chance of being approved for a mortgage on a home.
The Front-End Ratio or Housing Expense Ratio
This ratio shows how much of your gross (pre-tax) income would go towards paying your mortgage. The rule of thumb is that your monthly mortgage payment including principal, interest, real estate taxes, and homeowners insurance should not exceed 28 percent of your gross monthly income.
To calculate the front-end ratio multiply your annual gross income by 28 percent and divide by 12.
Annual Gross Income x .28 / 12 months = Maximum Monthly Housing (Front-End) Expenses
The Back-End Ratio or Debt-To-Income Ratio
This ratio shows how much of your gross monthly income goes towards servicing total debt. Do you have a bunch of other debt that you have to maintain including the mortgage? We're talking credit cards, car loans, student loans, child support and even alimony. Any debt obligation you have gets included in this ratio. The standard guideline is that your debt obligations should not exceed 36 percent of your gross monthly income. The lower the better. If you're debt-to-income ratio is higher than 36 percent then you might consider making some adjustments to decrease it, especially if you're looking to buy a home.
To calculate your back-end ratio (debt-to-income ratio) multiply your gross annual salary by 36 percent and divide by 12 months.
Annual Gross Income x .36 / 12 months = Maximum Allowable Debt-To-Income Ratio
So at this point you're probably wondering.
Why does any of this matter?
Because home prices are different around the country. In fact, a recent study from HSH.com show how much income you would have to make on an annual basis to afford a median priced home in a given metro area. They assumed a 28 percent front-end ratio and a 20 percent down payment.
Places where getting a home loan requires that you make some major coin.
Use this information as an initial screen for how difficult getting a home loan will be. If your income is in the ballpark required for the area you want to live in then you can calculate your front-end and back-end ratios to see exactly how much home you can afford.
These ratios are also helpful even if you're not buying a new home. If your debt-to-income ratio is higher than 36 percent then maybe consider looking for ways to eliminate debt. One way that could help is refinancing and consolidating your high interest debt. Let GoRefi help by getting a free personalized loan quote in less time then it takes to make a pot of coffee.