How Do Lenders Determine Mortgage Loan Amounts?

How Do Lenders Determine Mortgage Loan Amounts?

Purchasing real estate with a mortgage is often the most extensive personal investment most people make. How much you can afford to borrow depends on several factors, not just what a bank is willing to lend you. You need to evaluate not only your finances but also your preferences and priorities.

Key Takeaways

  • The general rule is that you can afford a mortgage that is 2x to 2.5x your gross income.
  • Total monthly mortgage payments are typically made up of four components: principal, interest, taxes, and insurance (collectively known as PITI).
  • Your front-end ratio is the percentage of your annual gross income that goes toward paying your mortgage, and in general, it should not exceed 28%. ? ?
  • Your back-end ratio is the percentage of your annual gross income that goes toward paying your debts, and in general, it should not exceed 43%. ? ?

How Much Mortgage Can I Afford?

Generally speaking, most prospective homeowners can afford to finance a property whose mortgage is between two and two-and-a-half times their annual gross income. Under this formula, a person earning $100,000 per year can only afford a mortgage of $200,000 to $250,000. However, this calculation is only a general guideline.”

Ultimately, when deciding on a property, you need to consider several additional factors. First, it’s a good idea to have some understanding of what your lender thinks you can afford (and how it arrived at that estimation).

While real estate has traditionally been considered a safe long-term investment, recessions and other disasters (like the 2020 economic crisis) can test that theory-and make would-be homeowners think twice.

While each mortgage lender maintains its own criteria for affordability, your ability to purchase a home (and the size and terms of the loan you will be offered) will always depend mainly on the following factors.

Gross Income

This is the level of income a prospective homebuyer makes before taking out taxes and other obligations. This is generally deemed your base salary plus any bonus income and can include part-time earnings, self-employment earnings, Social Security benefits, disability, alimony, and child support.

Front-End Ratio

Gross income plays a vital part in determining the front-end ratio, also known as the mortgage-to-income ratio. This ratio is the percentage of your yearly gross income that can be dedicated toward paying your mortgage each month. The total amount of money that makes up your monthly mortgage payment consists of four components, known as PITI: principal, interest, taxes, and insurance (both property insurance and private mortgage insurance, if required by your mortgage).

A good rule of thumb is that the front-end ratio based on PITI should not exceed 28% of your gross income. However, many lenders let borrowers exceed 30%, and some even let borrowers exceed 40%. ? ?

Back-End Ratio

Also known as the debt-to-income ratio (DTI), it calculates the percentage of your gross income required to cover your debts. Debts include credit card payments, child support, and other outstanding loans (auto, student, etc.).

In other words, if you pay $2,000 each month in debt services and you make $4,000 each month, your ratio is 50%-half of your monthly income is used to pay the debt.

However, a 50% debt-to-income ratio isn’t going to get you that dream home. Most lenders recommend that your DTI not exceed 43% of your gross income. To calculate your maximum monthly debt based on this ratio, multiply your gross income by 0.43 and divide by 12.

Mortgage lending discrimination is illegal. If you think you’ve been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).

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