Homebuyers typically pursue loans to finance 80 to 95 percent of the value of their home. Banks assess each applicant's suitability for a mortgage loan according to his individual financial circumstances. The maximum amount should be no more than the homeowner can comfortably afford to pay. Essentially this boils down to two factors: the borrower's monthly income versus his monthly expenditure.
Front End Ratio
As a general benchmark, lenders will finance buyers whose gross monthly mortgage commitment, including property taxes and insurance, does not exceed 28 percent of their gross monthly income.
Back End Ratio
Lenders look next at the borrower's debt. This includes all monthly payment commitments, such as housing, car loans, student loans and credit card minimum payments. If total debt is less than 36 per cent of gross monthly income, and without other factors, the borrower will typically qualify for a loan.
Lenders combine the two ratios in a 28/36 calculation. Put simply, the greater the debt a borrower carries, the less money he can borrow. For example, a $5000 gross monthly salary with no debt equates to a loan with maximum monthly payment of $1,400 (the 28 percent rule). Adding $600 of monthly debt (12 percent of monthly income) reduces the borrowing, as the homeowner has only 24 percent of his gross monthly income available to spend on housing costs (the 36 percent rule). This equates to $1200 per month -- a significantly reduced loan amount.
The 28/36 benchmark is not set in stone. According to Bankrate, conventional lenders offer income ratios of between 26 and 28 percent of monthly gross income, and debt ratios of 33 to 36 percent. For FHA-insured loans the equivalent ratio is 29/41.
Once the lender has determined the borrower's debt-to-income ratio, they apply an algorithm to determine the maximum loan amount. Other variables include the borrower's down payment, the annual interest rate (APR), and the mortgage term. Online calculators replicate the algorithm, giving borrowers a rough idea of their prequalification amount.
The maximum loan a homeowner qualifies for is not necessarily the same as the maximum loan he can afford to pay. The website Interest, quoting finance expert Liz Weston, recommends keeping housing costs below 25 percent of monthly income, rather than the industry standard 28 percent. Buying a house comes with additional expenditure that is not factored into loan entitlement, such as new furniture and decorations. Add an additional 1 to 3 percent of the cost of your home for annual maintenance and that affordable loan may not be so affordable.
Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a commercial writer. Her work has appeared on numerous financial blogs including Wealth Soup and Synchrony. Find her at www.whiterosecopywriting.com.