Just how much ‘house’ should a borrower purchase ?
Just as a potential home buyer hopes to find a well-suited living space and neighborhood environment that best satisfies their needs and lifestyle, their search for the funding source will be equally matched by a lender’s evaluation of their ability to repay the mortgage. While there are numerous qualifications and requirements to be met during the somewhat lengthy and often nerve-bending process, the lending institution is certainly going to focus their attention on some primary factors, such as credit history, a borrower’s gross monthly income, and the available cash resources accumulated for the down payment. These criteria all translate into what kind of house a borrower is able to ultimately afford, and the viability of a qualification begins by what is referred to as a ‘debt-to-income ratio’.
The Front-End Ratio
This formula is based on standard calculation which encompasses the housing expense, or front-end ratio, combined with the total debt-to-income, or back-end ratio. The front-end, or housing expense portion, is determined by how much of a borrower’s gross monthly pre-tax income can be applied to the monthly mortgage payment. As a rule, the monthly payment, which includes the principle amount of the loan, the mortgage interest rate, the real estate taxes, and homeowners insurance, must meet a ceiling of 28% of the gross monthly income figure. This can be self-determined by multiplying a borrower’s yearly salary by .28, and dividing that result by 12 ( months ). This figure equals the maximum housing expense ratio portion of the formula. As an example, if a prospective home buyer has a yearly salary of $40,000, the equation would be represented as follows: $40,000 x .028 = $11,200, and, $11,200 divided by 12 months = $933.33, the maximum mortgage-related payment per month.
The Back-End Ratio
The back-end ratio, or debt-to-income portion of the formula, is determined by compiling all of the debt obligations of the borrower, including the mortgage itself, any car loans, child support, credit accounts, and even student loans. When totaled, this figure represents a number that cannot exceed 36% of a borrower’s gross yearly pre-tax income. Again, the formula would be stated as: gross yearly income x 0.36 / 12 months = the maximum allowable debt-to-income ratio. Therefore, the lender is basing an evaluation on a figure that would look something like this: $40,000 ( annual income ) times 0.36 = $14,400, and $14400 divided by 12 months is $1200 – the total amount of debt repayment obligations per month. With these figures in hand, a prospective borrower can certainly get a sense of where the numbers fall in the lending qualification formula, and more effectively determine exactly how much house is financially feasible to purchase.