Mortgage lenders have a strict set of guidelines they adhere to when evaluating the ability of prospective borrowers to pay back a mortgage on time. These rules are meant to prevent borrowers from taking out mortgages they cannot afford while protecting lenders’ investments. In spite of their diligence, you should look at your finances very carefully before applying for a mortgage to make sure you do not take on more debt than you can realistically handle.
Housing Expense Ratio
Banks and mortgage companies use two ratios to determine the type and size mortgage they will approve you for: the housing expense ratio and debt-to-income ratio. To determine your maximum allowable housing expense amount -- which includes your mortgage payment, real estate taxes and homeowner’s insurance -- multiply your gross monthly income by 28 percent. For example, if you earn $4,300 per month, your housing expense figure should not exceed $1,200. If your dream home has real estate taxes of $250 per month and insurance will cost you $100 per month, you can take on a monthly mortgage payment of up to $850. To put it into perspective, a $190,000 traditional 30-year fixed-rate mortgage at 3.5 percent interest would have a monthly payment of roughly $850.
Most people would be ecstatic if their mortgage was the only debt payment they had each month, but that is rarely the case. Once you’ve determined the size mortgage you can handle by calculating your housing expense ratio, you must take your fixed debt into consideration. These debts mighty be credit card balances or personal, car or student loans. Most lenders will allow your total debt load to be no more than 36 percent of your gross monthly income. If your gross monthly income is $4,300, you may qualify for a mortgage if all of your debts plus your total housing expense do not exceed $1,548 each month. If you allocate the maximum of 28 percent, or $1,200 per month, for your housing expense, you may not qualify for a mortgage if your fixed debt load exceeds $348 per month.
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Some lenders might let you have a higher housing expense ratio if your overall debt load is fairly low. The Federal Housing Administration, for example, allows a housing expense ratio of up to 31 percent and debt-to-income ratios of up to 43 percent for FHA-insured loans. The Veteran’s Administration allows a debt-to-income ratio of 41 percent, but makes no stipulation on the housing expense ratio. Just because your lender allows you to take on more debt doesn’t mean you should. It's a good idea to leave yourself some breathing room financially so you have enough money left over to set aside emergency savings each month.
After your mortgage lender tells you what size mortgage it will approve, step back and take a realistic look at your income, bills and lifestyle. Remember that the ratio calculations are done on your gross income and not your take-home pay. The ratios do not take day-to-day living expenses into consideration, either. A family with six children, for example, could qualify for the same mortgage as a young couple with little debt, even the amount the two families spend on food, utilities and other living expenses each month are vastly different.
- single family home image by Karin Lau from Fotolia.com