Just as a potential home buyer hopes to find a well-suited living space that 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 to be met, the lender is going to focus attention on primary factors, such as credit history, their gross monthly income, and the cash resources available for the down payment. This all translates into what kind of house a borrower is able to afford, and the likelihood of qualifying is determined by the borrower’s ‘debt-to-income ratio’.
The Front-End Ratio
This formula is based on a calculation which encompasses the housing expense, or front-end ratio, combined with the total debt-to-income, or back-end ratio. The front-end portion is determined by how much of a borrower’s gross monthly pre-tax income can be applied to the mortgage payment. As a rule, this includes the principle, interest, real estate taxes and insurance, which must meet a ceiling of 28% of the gross monthly income figure. This can be found by multiplying a borrower’s yearly salary by .28, and dividing that result by 12. As an example, if a home buyer has a salary of $40,000, the equation is: $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 is determined by compiling all the debt obligations of the borrower, including the mortgage, auto loans, and credit accounts. When totaled, this figure cannot exceed 36% of a borrower’s gross yearly pre-tax income. The formula would be stated as: gross yearly income x 0.36 / 12 = the maximum allowable debt-to-income ratio. Therefore, the lender’s equation would be: $40,000 (annual income) times 0.36 = $14,400, and $14,400 divided by 12 months = $1200 – the total amount of debt obligations per month. With these figures, a borrower can determine exactly how much house is financially feasible to purchase.