Ugh. Math, debt and loans. Probably not most people’s favorite topics. Before your eyes glaze over while looking at terms such as financing and ratios, take a deep breath and remember how important this is to determine if you can get a loan for purchasing a house and how much house you can afford.
All mortgage companies evaluate your assets, income, credit and debts. Here’s an overview of how your income and debt matter to getting a home loan.
Determine Your Income
Lenders will consider your gross earnings each month (this is the amount before taxes are taken out). This includes recurring income that may be verified. Wages are the most common income form. Lenders will ask for documentation (such as W-2 forms) for the previous two years, which tells them how stable your earnings are. They might ask about any strange situations, such as changes in wages. Alternate income sources may include child support, investments and stocks. Any items that you would like counted must have valid documentation. A history of earnings and the possibility of continued earnings can be very helpful. The amount of documentation needed will differ among lenders and some exceptions can also apply. It is important to inform your mortgage advisor about all potential income sources for an accurate assessment.
Example
Household income from salaried job: $60,000 per year ($5,000 per month)
Alimony received: $1,000 per month
Total monthly income: $5,000 + $1,000 = $6,000
Calculate Your Debt
Debt describes all recurring liabilities such as credit card bills and installment loans. The specific monthly payments on loans and other structured debt are taken into account. For adjustable debt such as credit cards, minimum monthly payments are entered in the calculations. These amounts are normally noted in your credit report. Companies may agree to exclude debts with under a year remaining in payments or that you can verify someone else is responsible for. The amounts are totaled to identify your overall monthly debt.
Your recurring monthly debt will include things like mortgages, car loans, alimony, child support payments and credit card payments.
It does not include monthly expenses such as food, entertainment and utilities.
Example
Mortgage payment (including taxes and insurance): $1500 per month
Auto payments: $400 per month
Credit card total minimum monthly payments: $200 per month
Total monthly debt: $2100
Compare Your Income to Your Debt
Lenders compare the total income to debt to determine the income to debt ratio, which must stay under certain limits. The exact benchmark will vary from lender to lender and from program to program.
There are really two types of ratios that lenders will review to see how much house you can afford.
Front-end ratio: Your monthly housing payment (including taxes and insurance) divided by your monthly income.
Using the examples above:
$1,500 monthly mortgage payment (including taxes and insurance)
÷
$6,000 total monthly income
25%
Back-end ratio: All of your monthly debt payments divided by your monthly income.
Using the examples above:
$2,100 total monthly debt
÷
$6,000 total monthly income
35%
What Should My Debt to Income Be?
That varies.
The 28/36 Rule
In general, you can expect conventional loans to require your front-end debt-to-income ratio to be 28% or less. (Remember, that’s your monthly mortgage payment divided by your monthly income.) For your back-end ratio, conventional loans shoot for a debt-to-income ratio of 36% or less. (That’s your total monthly debt divided by your total monthly income.)
The 31/43 Rule
FHA loans are a little more forgiving – borrowers can have up to 31% of front-end debt-to-income, while allowing up to 43% for the back-end debt-to-income ratio.
Not the only rules
These are not hard and fast requirements. Some lenders will work with buyers whose debt-to-income values are over these ratios, though the mortgage will not be a Qualified Mortgage if the borrower’s back-end ratio is over 43%. If you are able to get a loan that is not “Qualified”, that might mean your interest rate could be higher or you pay more in fees to get the loan.
How Can I Tell How Much House I Can Afford?
If you know your monthly income and your total monthly debt (not including possible mortgage costs), you can use a handy calculator to see how high of a mortgage payment you can afford based on those 28/36 or 31/43 ratios above.
Which ratio should you use? That’s really up to you, the lender and financing program you choose. My personal recommendation is to keep your debt-to-income as low as possible to avoid as much stress as possible. Is a bigger house really worth living paycheck to paycheck? Though, this just doesn’t work for everyone.
Keep in mind that research shows that if your ratio is above the back-end 43% ratio, you are much more likely to have trouble paying the monthly mortgage.
Anything Else I should Consider?
There are many other considerations, such as FICO history and loan program restrictions. It is critical to contact a knowledgable lender for information on income to debt ratio for financing specific to your particular finances.
