How Do Lenders Determine How Much You Can Afford to Spend on Real Estate?Posted Wednesday, May 8, 2013
Mortgage lenders are primarily concerned with your ability to repay your real estate mortgage. They will consider your credit score, debt-to-income ratio and how much you have for a down payment before telling you what you can afford to spend on real estate.
One of the first things your lender will review is your credit score. Credit scores range from a low of 350 to a high of 850. In this case, the higher, the better. The lower your credit score, the higher your interest rate and points will be, and the lower the amount of home you’ll be able to afford. If your score is too low, you may not qualify for a mortgage. If your score is low, you may need to take some time to improve your credit score before buying real estate.
Lenders use a formula called the debt-to-income ratio to determine if your income is high enough and your debts are low enough to qualify for a certain loan amount.
Standard debt-to-income ratios are the housing expense ratio (also called front-end ratio) and the total debt-to-income ratio (also called back-end ratio). How are these calculated?
- Front-end ratio: Shows how much of your gross monthly pretax income would go toward the mortgage payment. As a general rule, the monthly mortgage payment, including principal, interest, taxes, and homeowners insurance, should not exceed 28 percent of your gross monthly income. To calculate the front-end or housing expense ratio, multiply your annual salary by 0.28, and then divide by 12 months. This is your maximum housing expense ratio. (Annual salary x 0.28/12 = Maximum housing expense ratio)
- Back-end ratio: This shows how much of your gross income would go toward all of your debt obligations – mortgage, car loans, child support, credit card bills, etc. Your monthly debt obligation should not exceed 36 percent of your gross income. To calculate this ratio, multiply your annual salary by 0.36, and then divide by 12 months. This is your maximum allowable debt-to-income ratio. (Annual salary x 0.36/12 = Maximum allowable debt-to-income ratio)
Last but definitely not least, lenders consider the amount you have for your down payment. The bigger your down payment, the less risk the lender is taking on, so you will probably receive a better interest rate. Ideally, you want to come up with at least 20% of the value of your new home as a down payment, to avoid things like mortgage insurance payments.
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