This is a common question I receive on a daily basis. Home buyers are trained to ask how much can their lender can pre-approve them for before they go out and start the home buying the process. Assuming your credit and down payment have been verified, lenders need to approve your debt to income ratio to ensure you are able and willing to repay your mortgage.
There are two ratios lenders consider before pre-approving you for a mortgage. The front end ratio is your housing expense (principal, interest, taxes, insurance, condo fees if applicable and mortgage insurance if applicable) over your gross monthly income. Lenders historically want to keep your front end ratio at or below 28% of your gross monthly income.
The back end ratio is your minimum monthly debt, which includes your total mortgage payment (front end housing ratio) and minimum debt listed on your credit report. This includes:
· Installment debt: student loans, personal loans and car loans.
· Revolving debt: credit card debt
· Mortgage debt: any first or second mortgage loans
Lenders will also need to know if you are responsible for any alimony or child support. Lenders are not concerned with other reoccurring debt you may have, such as: utilities, cable, cell phone bills, groceries, etc. To calculate your total debt to income ratio or back end ratio, we take the total of minimum monthly debt over your gross monthly income.
Depending on your mortgage product your debt to income ratio for conventional financing allows for ratios at or below 45% while FHA financing allowing for slightly higher ratios with compensating factors. Prior to the recent housing bubble, lenders where approving financing for borrowers up to a 55% debt to income ratio. These higher ratios are believed to be one of the reasons that fueled the real estate bubble.
The mortgage environment is constantly changing and lenders are once again concerned with the borrower’s ability to repay their mortgage. Congress and the CFPB (Consumer Financial Protection Bureau) are concerned that too many consumers are still being placed in mortgages that they cannot repay. Starting on January 10, 2014 lenders are required to assess the borrower’s ability to repay virtually all residential mortgages. One the major changes with all Qualified Mortgage loans (QM) is the lowering of a borrower’s debt to income ratio. In order to get approved for most residential mortgage products the borrower’s back end ratio or total debt to income ratio must be at or below 43%. While this may not seem like a big change, it is important to realize your buying power is being reduced.
It is important to work with your lender to get pre-approved well before you start your home search. A pre-approval means your lender has done a full credit analysis, verified your income, verified your assets and has an understanding of your short and long term housing goals.
Whenever I am asked, “How much can you pre-approve me?” my answer is always, “Depends, how much do you want to spend?” It is important to realize what your total housing comfort level is when getting pre-approved for a home. Every borrower is different and depending on your individual situation you may be more conservative or be comfortable with a higher housing payment than your friend or neighbor.
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While you need to properly pre-approved before making an offer, you should start with a budget and an understanding how much you can afford. Just because you are pre-approved for a certain loan amount, does not mean you should go and buy that house.
Craig Barber of Fairway Independent Mortgage in Boston MA.
The author is solely responsible for the content.