Mortgage Advice
Mortgages

Understanding Mortgages: The Formulas of Mortgage Approval

In the midst of one of the most uncertain real estate markets in history, it’s more important than ever to be informed. In a continuing series, we take a look at some of the most pressing questions about mortgages, refinancing, home equity, and other real estate options available to you.

(8/23/2012) For some potential homeowners, and particularly first-time buyers, the idea of getting a home loan can seem overwhelming and difficult. But the truth is when credit is good and ratios of debt to income are within reason, many borrowers will find that the process of getting approved for this mortgage is easier than they anticipated. The difficulty comes in finding the loan that can be approved by lenders, and still work best for the borrower.

Smart borrowers know that a first step to purchasing a home is a mortgage pre-approval. This official process allows borrowers to see what they can qualify for in terms of a home mortgage. Getting this pre-approval is an important step towards eventually getting a mortgage, as many of the key items considered during underwriting are examined here.

When considering a home purchase, many borrowers may be surprised at what they can technically qualify for. They then naturally look to the highest loan amount and thus the most house they can possibly get. But a mortgage must also make sense for you and your finances. It makes sense then to consider the formulas that lenders use when reviewing and approving a loan as a means of determining the best loan amount to pursue.

The first is percentage of gross income. This formula determines loan eligibility, and is based on the rule that monthly mortgage payments should not exceed 28% of gross income. If you consider a $50,000 gross income, a mortgage payment should not exceed $14,000 per year or $1,666 per month. That monthly total needs to cover the actual mortgage, but also the interest, taxes and insurance involved in the home purchase. The formula can seem very logical and clear to lenders and to borrowers. But here’s the trap many borrowers can fall into - although mortgage eligibility is based on gross income, borrowers are actually paying out of net income. That reduces the monthly pool from which to pay for mortgage payments and all the other expenses of life. And that can result in signing on for a bigger loan than borrowers should.

The other formula that lenders consider is debt-to-income ratio. Generally the rule is that this ratio should not exceed 36%. Considering the $50,000 yearly gross income example, total monthly debt should not exceed $1,500. That debt includes mortgage, car payments, credit cards, and all other debt. Similar to the previous ratio, borrowers can often forget that total monthly debt must be paid out of net income, which may be more of a strain.

Borrowers should sit down with calculators and think through all the figures listed here in order to determine what can actually be afforded. Homeowners can often fall into the trap of taking a large loan because they qualified for it. They can then have trouble making monthly payments. Or they can be one large expense away from disaster. If on the other hand borrowers find a house for less than the maximum loan offered by lenders, the result can be more discretionary income and more options down the line.

For additional reading:

Mortgages: The Basics
http://www.bankrate.com/brm/mstep.asp

6 Tips to Get Approved for a Home Mortgage Loan:
http://www.moneycrashers.com/getting-approved-mortgage-loan/