The excitement of buying a home often gives way to upset and misunderstanding when it comes time to apply for a mortgage. Terms like "debt-to-income ratio" and "mortgage insurance" suddenly become of paramount importance. Understanding the mortgage underwriting process before you begin your search will help you avoid the disappointment of discovering the home of your dreams is beyond your reach.
Debt-to-Income Front-End Ratio
The most important metric that a mortgage lender considers during the underwriting approval process is the debt-to-income ratio, which tells the bank how easily you'll be able to afford the payment. The rule of thumb is that no more than 28 percent of your gross (before tax) monthly income should be earmarked for housing. For example, if you earn $5,000 per month before taxes, no more than $1,400 -- 28 percent of $5,000 -- should be spent on your mortgage, taxes and insurance payment. This is known as a front-end ratio.
Debt-to-Income Back-End Ratio
Lenders also consider your other debts, including car payments, student loan payments and credit card bills (only the minimum monthly payment is considered, not the entire balance due). The underwriter will add those fixed monthly expenses to your front-end ratio number, which should ideally total no more than 36 percent. In our $5,000 example, an additional $400 per month would be allowable toward these debts. Automobile and life insurance costs are not factored into the debt ratio.
These lender "rules" are actually guidelines in practice, and can be raised or lowered depending on the applicant's personal financial picture. For example, a borrower with stellar credit, ample savings and a solid employment history will find that the ratio may be raised, perhaps as high as 41 percent on the back end. This is known as an exception.
Also, applicants who qualify for special government lending programs, such as veterans, will find looser lending restrictions and ratios.
Remember that although you may qualify for an exception, you may not be able to afford it. If you're counting on paying only the minimums on your credit cards, for example, you should strongly reconsider the exception.
What Affects Your Ratio
Three factors most affect your ratio: your down payment, credit score and the amount you're looking to borrow. Of course, the more you put down, the lower your front-end ratio will be because your mortgage payment will be less (your interest rate may also be lower). If you have poor credit, you may find that your interest rate will be high, which will increase your payment and reduce your buying power. You may also find your loan application denied.
Lastly, if you are putting less than 20 percent down, you may find yourself paying mortgage insurance, which is included in your housing payment. Fifteen-year mortgages have higher payments than 30-year notes, and will increase your housing payment as well (even with a lower interest rate).
Do your research in advance: get your credit score, pay your bills on time (and in full, if possible), save money when you can and only consider houses you can truly afford, and you'll be well on your way to homeownership.