All the budgeting metrics that are important from a mortgage lender's point-of-view. This guide will teach you roughly how much you qualify for without talking to a lender
The first step to any home buyer's journey is to determine "how much home" you'll be able to afford, so you're able to start searching for homes in a price range that works for your unique situation.
You won't be able to determine all the figures before you talk with your lender (interest rates are constantly changing), but you can get a decent enough estimate.
The things you need to figure out are:
- Your Lifestyle Budget
- Total home price and monthly payments
- Your Budget from the Bank's Point-of-View (DTI)
- Liquid Assets (Money you can touch now without tax and penalty)
- Solid Assets (Money you touch will be taxed and penalized)
- Loan-to-Value Ratio
We firmly believe that you should start with your financials before you start looking for homes. Doing it the other way around often leads to heartbreak.
If you've worked through our home search tutorial, you'll have already worked through your lifestyle budget.
We suggest using the consumer.gov budget calculator as it gives a comprehensive and easy-to-use glimpse at your lifestyle budget.
We recommend taking a very critical look at your future plans and pricing all likely (and unlikely) eventualities to be confident you'll be able to afford your mortgage over its term.
Once you've carefully tailored your budget and home choice - and you feel comfortable and confident in your ability to manage it - congratulations, you're ready to move on.
Now that you've figured out your budget, you know how much money is leftover to spend on a mortgage.
Keep in mind that you can subtract your rent costs - as you would no longer be paying them if you took up a mortgage.
You can find both the total asking price, and monthly mortgage payment, by playing around with the calculator tools found on various listing sites:
- Redfin for example provides a "Payment Calculator" within their listings - you can play around with the various options to see what sort of monthly payment you'll be dealing with.
- Zillow also offers this calculator tool under "Monthly Cost" featured within each listing.
- Realtor.com features this tool under "Monthly Payment" featured within each listing.
Pick any home of any price range, and try to get a feel of what monthly price tag is attached to each total home price.
Factor this information into your budgeting - and see if the monthly payment structure is comfortable or anxiety-inducing.
Keep playing with the loan term, down payment, and home cost until you come to a decision on what sort of asking price, and subsequent monthly payment, seems viable for your situation.
What you consider as your total budget, and what the bank considers - are two different things.
Personal budget: every expense you undertake monthly vs. your net income
The goal is to determine how much leftover money you have in your budget after your credit report related debts are dealt with, and comparing those numbers with your gross income.
So what are all the debts you need to include in this section?
- Loan-related debts -> Student loans, auto loans
- Other Monthly Debts -> Child support, alimony, personal loan payments
- Credit Payments -> Credit cards, lines of credit
Here's a spreadsheet template we've built so you can easily determine your mortgage related budget and get your debt-to-income ratio (DTI) to refer to in the next section:
Your DTI ratio is a major factor in determining your elibigility to get a loan and is calculated with the following formula:
DTI Ratio = Obligated Debts / Gross Income
Lenders use DTI ratios to determine the risk level of the loan.
There are four types of loan sizes in California, each type has a DTI ratio threshold; you won't qualify for the loan if your percentage is too high.
Figures below based on LA County loan limits:
|LA County Loan Types||Loan Limit||Top Ratio||Bottom Ratio|
Front-End Ratio (Top Ratio)
- Housing Expenses divided by income
Back-End Ratio (Bottom Ratio)
- Housing expenses plus all obligated debt divided by income
So for a super simplistic example:
For a couple that has $15000 in monthly take-home-pay with a $4000/month mortgage and $1800 in monthly costs (not including rent), their DTI ratio would be:
- Front-End Ratio: $4000/$15000= 26.66%
- Back-End Ratio: $5800/$15000= 38.66%
In our example the couple would qualify for any type of loan - as you can see on the table above. Their incomes outweigh their debts, so a lender would view them as lower risk - and be likely to approve them for a loan.
If you're above the limits, play around with the numbers are see what would happen if you eliminated one of your debts, or received a long-awaited raise.
Your liquid assets are any assets you have that you can instantly cash out. This includes but isn't limited to checking accounts, some savings accounts, investments, and gifts from family members.
The purpose of knowing these is to determine how much of a down payment you can afford.
If your down payment is less than 20% - you'll have to get private mortgage insurance (PMI) - which will be calculated on the percentage you are putting down (5% vs. 10% vs. 15%) & Middle Credit Score.
Whatever amount you're looking to put down - you'll want to have that available in your liquid assets category to be taken seriously by a lender.
After you put your down payment, the amount you have leftover is considered your reserve tank.
But lets say you get hit by a bus, or struck by lightning.
How would you still work and keep paying the mortgage?
Depending on which loan bracket you fall into, lenders will ask you to keep a certain number of months worth of mortgage payments in your reserves until can get back on your feet.
As mentioned above, down payments lower than 20% will generally require you to purchase private mortgage insurance (PMI). You'll be required to pay this until your home equity reaches 20% or higher.
The reason behind this is the perceived risk from your lender.
The more home equity you're able to purchase outright, the more your lender will see you as a reliable investment that will be less likely to default.
If you have a low down payment, PMI isn't the only additional cost - your interest rate will be higher as well.
From the lender's perspective, an individual who puts 3% down on a home would be considered very high risk.
Being only human, they want to protect their investment, so they rely upon PMI and an increased interest rate to ensure that they don't expose themselves to large losses upon a person's inability to maintain their mortgage.
Lenders use loan to value ratio to determine the level of perceived risk on a loan. The formula for LTV is quite simple: Mortgage Amount (MA) divided by Appraised Property Value (APV).
You can easily calculate LTV using online tools like the one featured here:
If you've gotten this far and managed to come to a comfortable budget, are within the DTI ratio limits, and decided which down payment is right for you with the assets to fuel it.
Aside from FICO score considerations - you're completely financially prepared.
Getting a loan should be an absolute breeze.