Capacity
There are three pieces to figuring out your capacity:
1. Monthly Debt: for home buying purposes, your debts are defined as payments to:
- Credit cards
- Home equity loans, personal installment loans, debt consolidation loans, education and vehicle loans
- Alimony and child support
If you can, you should try to pay down these debts before applying for a mortgage. Even if you have a high income, you may not qualify for a lowrate loan if you are carrying a lot of monthly debt.
2. Monthly Housing Expense: this is the amount you will have to pay to live in the house you want to buy. It is the homeowner’s equivalent of rent and it includes:
- mortgage payment
- property taxes
- homeowner's insurance premium
- mortgage insurance (if required)
- other expenses like Condominium or Home Owner’s Association fees (if required)
Since most people don’t pay their property taxes and insurance premiums monthly, this number can be a surprise. But the lender wants to make sure you have enough income to cover all of the expenses of the home, so they will calculate it on a monthly basis.
And in many cases, if you are putting down less than 20% of the selling price, the lender will require that you pay the taxes and insurance from an impound account that you pay into monthly. So when the mortgage payment coupons arrive, they are for an amount that includes not just the loan principal and interest, but also taxes and insurance.
3. Monthly Income: any verifiable form of consistent income can be used to qualify you for a mortgage:
- part-time salary
- overtime
- commissions
- disability payments
- alimony and child support
- seasonal income that can be proven for two years running
Lenders are looking for money that you, and they, can count on; so the longer you have worked in a career, and a job, the easier it is to qualify for a loan.
How They Do The Math:
To come up with your borrowing capacity, the lender takes your monthly consumer debt and housing expense, divided by your monthly income.
You can do this too. You can do the calculations for yourself so you know when you’re getting a good deal.
These two numbers are called your Front Ratio and your Back Ratio, and they are tools for measuring your financial situation that lenders have developed over time to make sure they aren’t lending money to people who won’t be able to pay it back.
Front Ratio: this number is your monthly housing expense divided by your monthly income (before taxes). A common term for housing expense is your PITI or:
- P: Principal of the mortgage payment
- I: Interest of the mortgage payment
- T: Taxes
- I: Insurance: both property and mortgage insurance
- (and any condo, coop or Home Owner’s Assoc. fees)
For a lot of first-time buyers, the total of all these things is going to be their monthly mortgage payment.
So if you and your spouse together make $4,000 a month (before taxes) and your monthly PITI adds up to $1,040, your front ratio is a healthy 26%
$1,040 = 26% $4,000
To get a traditional, low cost loan, this number is best below 28%, but many lenders have programs and loans which can work for you, even if your front ratio is higher that 28%. Supporting Content Box B, Supporting Content Box C
Back Ratio: this number is the combined total of both your housing expense and your debt payments divided by your monthly income. The debt number includes your credit card payments, any car or boat loans, any personal loans, and any child support or alimony owed.
It doesn’t include household expenses like food, utilities and clothing.
So if you make $4,000/month, have a PITI of $1,040, and have credit cards with monthly minimum payments of $300 and a car lease of $59.95/month, your back ratio is 35%.
$1,040 + $300 + 59.95 = 35% $4,000
Traditionally, it’s best to keep this number below 36%, but lenders and the FHA government programs have lots of options available if you have a higher back ratio. Your capacity is just a part of the lender’s calculation: collateral and credit can be just as important.