Lenders examine borrower finances very carefully when deciding what type of mortgage to approve and grant so the borrower can purchase a home. If the borrower shows risk that they may not have enough income to make mortgage payments, the lender may raise interest rates or require larger down payments in order to make the loan—or they may reject the loan application altogether. Borrowers can use the same ratios that lenders examine to see if they have a good chance of getting a traditional mortgage.
There is no single ratio that will tell a lender everything it wants to know about the borrower, but lending companies do use two very important equations in their analysis, the housing ratio and the debt-to-income ratio. The housing ratio divides all related house expenses by the borrower's gross monthly income. The gross monthly income is the total amount of revenue that borrowers may through any sources of profit, before any personal taxes or expenses have been subtracted. For this ratio, lenders assume that the borrower already owns the property they want to purchase, which means lenders also require a specific house that the borrower intends to purchase.
Housing expenses is a general term, and calculating the total amount of monthly expenses can take time if the borrower does not all the financial information related to the property they want to buy. Homeowners insurance can vary, but is usually computed as an annual amount and then divided by twelve. Property insurance also varies by the size and location of the house, but tends to average out to around $30 a month. Lenders may also count other required housing expenses like homeowner's association dues.
The debt-to-income ration is a more general version of the housing ratio. This ratio examines gross monthly income compared to fixed debt expenses. Fixed debts are any payments that the borrower has to make every month—like other loan payments, insurance premiums, payments on credit lines, tax payments, any legally required payments like alimony, and any debts also included in the housing ratio. This shows how much debt the borrower has in relation to the ability to pay the debt off, another vital consideration for lenders.
Ideally, the housing ratio should not be greater than 30 percent. The debt-to-income ratio can be a little higher, but debt should still not be much more than 30 to 40 percent of gross monthly income. If debts start to approach 50 percent, lenders will not consider loan applications at all. For higher ratios, lenders may agree to granting a loan with a higher interest rate, or they may require the borrower to get mortgage insurance.