One of the major areas of stress in the home buying process is the mortgage approval process on a home you wish to buy. Since you are not quite ready to contact a lender (which, in most cases, you’ll need to do before contracting for a home), it seems to make sense that you might want to review the mortgage underwriting process and understand the mathematical calculations a lender uses to qualify you financially. As most of us will be applying for a conventional mortgage loan, we will show you in the following paragraphs how the underwriting process works as well as how the lender determines the payment amount you would be approved for. Information on government and specialized mortgage programs will be covered in later posts. What will a lender look for in underwriting your mortgage loan? When you apply for a mortgage, the lender will look at 3 major areas – Your credit – Your credit history is the number one underwriting criteria that lenders look at. They rely on your credit scores, which “grades” you on the way your handle money and pay your obligations. The agencies that provide this information are Equifax, Trans Union and Experion. As this is the lender's number one criteria used in their decision process, You should check your credit score from all three agencies to check for inaccuracies, so they can be addressed before hand. These reports are free once a year or if you are turned down for a loan. It’s also important to check for inaccuracies so they can be addressed before hand.
Your Down Payment - This is the dollar amount, before closing costs, that you plan to invest towards the purchase of your home. Lenders will usually require mortgage insurance or a guarantee, in the case of VA loans, that protects the lender if you are putting less than 20% down.
Your Verifiable Income - This represents the income that you reported on your tax returns for the past 3 years. It is iportant to note that the lender will not count income that has not been reported on your tax returns, so be prepared, in advance, to provide documentation to confirm your income.
Determining the maximum payments a lender allow you to pay As noted above, the lender will only use income that has been verified through your tax returns and other supporting documentation. Therefore, the maximum payment will be based on your verified gross income.
Here’s how the process works –
Your Down Payment - This is the dollar amount, before closing costs, that you plan to invest towards the purchase of your home. Lenders will usually require mortgage insurance or a guarantee, in the case of VA loans, that protects the lenderif you are putting less than 20% down.
The lender uses 2 qualifying ratios - Mortgage Payment to income ratio – The lender does not want you to pay more than 28% of your gross monthly income towards your total mortgage payment which includes the mortgage principal and interest payment, monthly real estate taxes, monthly homeowner’s insurance premium, monthly HOA and/or condominium dues, and, if applicable monthly private mortgage premium.
Your Debt-to-Income Ratio - The lender does not want you to pay more than 36% of your monthly income towards your total mortgage payment and other recurring monthly payments which includes the mortgage Payment calculated above, auto lease and/or financing payments, student loans and minimum payments applicable to all credit cards, even if paid in full each month and other installment payments. Both ratios can be adjusted at the discretion of the loan underwriter based on your overall financial history, credit, length of remaining payments, job stability and income growth potential.
Figuring the maximum payment you can qualify for
Step 1 – Calculate your Mortgage Payment to Income Ratio (how much of your gross income can be used for a mortgage payment). For this illustration, we will use $6000 a month as your verifiable income.
While the underwriter can us ratios as high as 40%, we'll use the base ratio of 28%. Simply take your gross monthly income of $6000 and multiply by .28 (the decimal equivalent of 28%). This will give you a figure of $1680 which can be used for your mortgage payment.
Step 2 – Calculate your Debt-to-Income Ratio (how much of your gross income can be used for all your recurring payment) As in Step 1, we will use your $6000 a month as your verifiable income - Included in this calculation are the following - Monthly mortgage payment as calculated in Step 1, Auto lease and/or financing payments, Student loans, Minimum payments applicable to all credit cards, even if paid in full each month and any other recurring payment obligations.
While the underwriter can use ratios as high as 45%, we'll use the base ratio of 36% –
Simply take your gross monthly income of $6000 and multiply by .36 (the decimal equivalent of 36%). This will give you a figure of $2160 which can be used for your mortgage payment and other recurring payments.
How do I figure out if I will qualify for a mortgage?
Let's look at this example from one of our viewers
This couple found a home listed for $375,000 that they want to buy. The real estate taxes are $2904 per year, HOA fees are $55.00 per month, and Homeowners’ insurance is $1104 per year. They are putting 20% down ($375,000 X .20 = $75,000), therefore, mortgage insurance is not required. Based on their verified income of $6000 per month, will they qualify for the $300,000 loan they will need to buy this home?
Step 1 - Calculate your mortgage payment. To determine your mortgage payment, simply go on Google and search for “mortgage calculator”. There are dozens available for free. In this example, we have used a calculator provided by U.S. Mortgage. To use this calculator, click here and fill in the following; Mortgage amount $300,000 (House price less down payment), Mortgage term in years 30, and Interest rate per year 3.125% – current rate as of date of this post, click enter on your keyboard .
In this example, the monthly mortgage payment is $1285.13. To this, input the annual real estate taxes and annual home owners insurance premium and monthly HOA fees. In this illustration, this totals $389 / month. To complete this calculation, add the $389 recurring debt to the mortgage principal and interest payment of $1285.13 which comes to $1674.13 per month.
To figure out if you qualify for the mortgage using the mortgage to income ratio, divide your monthly income by .28 (28%). In this example, this comes to $5982 which means that you would qualify under the mortgage payment to income ratio.
Step 2 - Calculate your total recurring payments to determine if you qualify under the second ratio, the Debt-to-Income Ratio.
In this example, this couple had the following recurring monthly payments, an auto loan of $309, a student loan $136, and minimum payments on two credit cards $30.
To figure out if you qualify for the mortgage under the Debt to Income Ratio, divide the monthly income by .36 (36%). In this example, this comes to $6000. Since the mortgage payment plus your recurring monthly payment obligations totals $2149, this couple financially qualified under both ratios.
The ratios we used are ultra conservative and are flexible assuming you have a stable income and a good credit history. Should you not qualify under these ratios, there are many excellent programs out there that in most cases can mean that you still can buy that dream home.
It is important to know that most sellers are going to require a pre approval letter (which means that you income, assets and credit have been underwritten by the lender) with an offer, so contact a to a reputable mortgage banker or credit union, not a mortgage broker, who will furnish this letter at no cost to you (except possibly the credit report).
As always, if you need further guidance, just contact us.