Mortgage lenders decide how much you can borrow, for the most part. But that does not mean you have to take only what they give. What you can borrow is usually determined by your percentage of gross monthly income, debt to income ratio, your credit score, and the amount of money you are willing to put down.
When you visit your lender to get a mortgage for your home, they will tell you the maximum amount you can borrow. But how do they reach this total, and what factors do they take into consideration?
How do they determine that one borrower can take on a bigger mortgage than the next? Mortgage companies make this decision by considering a wide range of factors, including your credit information, your salary, and much more.
1. Percentage of Gross Monthly Income
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Ideally your monthly mortgage payment should never exceed 28% of your gross monthly income. With that said, every borrower’s daily living expenses are different, and most mainstream conforming loan programs as well as FHA and VA programs allow you to exceed that threshold.
This will ensure that you are not stretched too far with your mortgage payments, and you will be more likely to be able to pay them off. Remember, your gross monthly income is the total amount of money that you have been paid before deductions from social security, taxes, savings plans, child support, etc. Note, when factoring in your income, you usually have to have a stable job or proof of income for at least two years in a row for most lenders.
2. Debt to Income Ratio
Another formula that mortgage lenders use is the “Debt to Income” (DTI) ratio, which refers to the percentage of your gross monthly income taken up by debts. This takes into account any other debts, such as credit cards and loans. Here, lenders will look at all of the different types of debt you have and how well you have paid your bills over the years. Typically, a DTI of 50% or less will give you the most options when qualifying for a mortgage.
So, if you are looking for a conforming loan or a conventional loan through Fannie Mae or Freddie Mac, a DTI anywhere from 45% to 50% is highly recommended. In contrast, an FHA loan has different guidelines. However, those who qualify for this particular loan type may be looking at a DTI of 38% to 45% with a low credit score. That said, if you have an average or above-average credit score, then in most states, you can have a higher DTI, up to 57% in some cases. VA loans also allow for a higher DTI (up to 60% for fixed-rate loans and a max of 50% for adjustable-rate mortgages).
It is important to note that just because you qualify doesn’t make borrowing the highest loan amount possible a good financial decision. Factors such as expected future income, your lifestyle spending and potential future expenses such as college should all be considered before deciding how much you can afford.
3. Credit Scores
As suggested above, another pivotal way that lenders determine how much you can borrow is by factoring in your credit scores. In its most basic terms, your credit score is a three-digit number that shows how you have borrowed and repaid money in the past. A potential borrower with a higher score is considered less of a risk. Alternatively, a lower score indicates that you may be a potential or higher risk to the lender. Ultimately, this matters because borrowers with excellent or even great credit tend to have an easier time qualifying for mortgage loans. This is especially true, even if their debt-to-income ratios are a bit high.