Pre- approval pt 2. How much house can you afford?
Getting a pre-approval will determine the monthly mortgage payment you can afford.
Do you want to buy a house and don’t know how or where to start but you’re wondering how much you can afford? Or you’ve just started your journey to finding your sanctuary and homeownership but wondering how lenders determine how much you qualify for? We always counsel to start with a lender to find out where you stand financially in order to attain a mortgage. That means determining where you are at financially in relation to being pre-approved and receiving a pre-approval letter to present to a realtor letting them know that your in a good position to purchase a home.
Getting pre-approved and your approval letter is the first step. The truth is most people have no idea on how a loan officer arrives at a potential homeowner being in a good position to be pre-approved for a loan. Well, read on dear reader we’re here to help in advance to a good loan consultation and a clear and determined mortgage ready plan.
In order to qualify for a mortgage, and to understand what you may potentially qualify for, there are 3 base components.
· Credit Score (FICO)
· Income
· Debt
When you approach a lender to get pre-approved for a loan, a loan officer will start with these three factors. Let’s break these down on how it relates to what you may qualify for when it comes to your mortgage.
CREDIT SCORE
Your FICO score will help determine your interest rate. The long and the short of it is the higher the credit score the lower your interest rate. Something to note regarding you credit score is that companies like Credit Karma and Creditwise utilize a different FICO scoring model than what is used for mortgages.
It is a common occurrence for those companies to have FICO scores 50 to 100 points higher than a mortgage FICO scoring model.
To gain an accurate understanding of an accurate FICO score we recommend using:
· AnnualCreditReport.com
INCOME
Income helps to establish your pre-approval loan amount. Keep in mind though when you first apply for a pre-approval, you aren’t really approved for a dollar amount. Rather you are approved for a mortgage payment. More on that in a moment.
DEBT
Or rather your debt in relation to your income. Commonly referred to as as DTI. Debt to Income Ratio. Your DTI will mandate what your monthly mortgage is and that in turns informs how much of a loan you should safely be approved for.
So how does it all work?
When a loan officer determines your approximate monthly mortgage, they will make a best “guestimate” to incorporate property taxes and insurance. Keep in mind I say guestimate because they will most likely use area averages for things like property taxes and insurance because those eventually will really determined by an actual subject property. Your interest rate isn’t even finalized until your loan gets to closing. They may even incorporate Private Mortgage Insurance (PMI) if applicable and Home Owners Association (HOA) dues also if applicable. Some will give you a cushion to allow for higher taxes and insurance while others will give you Highest Cost Use. That’s why you will get different approval amounts when you compare loan quotes from different lenders.
DTI is calculated by starting with your gross monthly income and multiplying it by a maximum allowable percentage. According to the Consumer Finance Protection Bureau (CFPB), 43% is often the highest DTI a borrower can have and still get a qualified mortgage. However, depending on the lender and the loan program, borrowers can qualify for a mortgage loan with a DTI of up to 56% in some cases.
Well use the highest 56% for our example. If you make $5000 gross per month. We’ll take that number and multiplying it by a factor of .56. So 5000 x .56 or 5000 x 56% on the calculator will yield $2800.00 a month. That is the maximum mortgage payment you can have without any debt. From there we’ll end up deducting your debt. Some examples of revolving credit are items such as credit cards, personal lines of credit or business line of credit or deposit accounts with overdraft protection. Other debt that will be subtracted from your allowable total would be installment loans such as car loans, personal loans student loans. Pretty much anything with the term loan attached to it. Medical debt may also factor in your DTI.
Let’s say you have a $400 monthly payment in the form of a car loan, and $275 in credit card debt and $225 in student loans. That’s a total of $900 a month. We subtract those monthly debts from the maximum amount of $2800. ($2800 - $900) = $1900.
Based on your current DTI your maximum allowable mortgage would now be that $1900. That amount would have to include Principal, Interest, Taxes and Insurance. Also where applicable Private Mortgage Insurance (PMI) and Home Owners Association HOA) dues.
Then your loan officer would figure out your maximum approval amount by configuring how much house would have an estimated $1900 monthly mortgage payment. That is how your pre-approval is determined.
Ultimately, lenders value low DTI, not high income. Your DTI compares your total monthly debt payments to your before-tax income.
If the amount doesn’t work for you and want to be approved for a higher mortgage payment. There are things you can do to alleviate that.
You can put more money down.
You can increase your income.
You can decrease your debts.
Or you can effectively combine any of three factors into eventually obtaining a higher mortgage payment. Also see our post about a loan consultation and how to make the consultation work for you.