Your income determines how much loan you can afford, but it’s not the only factor. Your expense ratio is one of the largest determining factors. The amount of your income committed to your monthly bills shows lenders what you have to spend on a mortgage. If your ratios are too high, you become what they call a ‘high risk borrower.’
The Front-End Expense Ratio
The front-end expense ratio is how the new mortgage payment will affect your income. It shows lenders how much the monthly payment will stress your income. It takes into account the principal, interest, real estate taxes, homeowner’s insurance, and mortgage insurance.
Here’s an example:
You make $75,000 per year. Monthly that comes out to $6,250. This is your gross monthly income. Let’s say you apply for a $200,000 mortgage and the lender quotes you a 5% rate. Your principal and interest payment would be $1,074.
Don’t forget, you have to add on real estate taxes and homeowner’s insurance. In this case, let’s say your real estate taxes are $5,000 per year and your homeowner’s insurance is $900 annually. This means $417 a month for taxes and $75 a month for insurance. Your total housing payment, assuming you don’t need mortgage insurance equals $1,566.
To figure out your expense ratio, you would do the following:
$1,566/$6,250 = 25%
The type of mortgage program you apply for will determine if this is an acceptable ratio. In general, the following ratios apply:
- Conventional loans – 28%
- FHA loans – 31%
- USDA loans – 29%
The Back-End Expense Ratio
Your front-end ratio isn’t the only ratio lenders worry about. They also consider the back-end expense ratio. In other words, how much money you must pay out every month compared to your income. This ratio includes not only the new monthly mortgage payment but also any other debts you have. A few examples include:
- Minimum credit card payments
- Car loans
- Student loans
- Personal loans
Any payments that report on the credit report must be included in your debt ratio. The lender will total up the monthly payments and add them to the potential mortgage payment.
Let’s say you have the following:
- Car loan $300
- Credit card payments $75
- Personal loan $150
This is a total of $525. Using the above example, we’ll add this to the mortgage payment of $1,566. This gives you a total debt ratio of:
$2,091/$6,250 = 33%
Just like the front-end ratio, each program has a maximum back-end ratio:
- Conventional loans – 36%
- FHA loans – 43%
- USDA loans – 41%
In our example, you would be eligible for most programs based on your back-end ratio.
Other Factors Affecting Your Mortgage Application
Of course, the expense ratio isn’t the only factor affecting your mortgage approval. The lender will look at the big picture. They usually start with your credit score. This determines if you are even eligible for the program. Every program has a minimum, but it is also up to lender discretion. The basic requirements are as follows:
- Conventional loans require at least a 620 score, but most lenders require a higher score, usually one of at least 680
- FHA loans require at least a 580, but again, most lenders require a higher score
- USDA loans require at least a 640 credit score
After your credit score, lenders look at your type and length of income/employment, your assets, and your credit history.
It’s like a big puzzle that they put together. One ‘bad’ factor doesn’t necessarily mean you won’t qualify for the loan. Take the expense ratio for example. If you have a 37% back-end ratio, it doesn’t mean you are automatically ineligible for the program. The lender will look at your income, employment, and assets. They look for what they call compensating factors. A few good ones are as follows:
- Do you have a high credit score? Having a score that exceeds the minimum, putting you in the ‘excellent’ category can help your chances of approval. It shows financial responsibility and that you can handle a slightly higher debt ratio.
- Do you have assets on hand? How many mortgage payments would they cover? Lenders call these reserves. The more reserves you have, the greater your chance of approval.
- Have you been at the same job for several years? Job stability shows the lender that you are consistent and dependable.
- Has your income steadily increased over the past few years? This shows the lender more financial responsibility and the potential to progress.
Your expense ratio is a big piece of the puzzle, but it’s not the only piece. Make sure to work on every aspect of your mortgage profile before applying. The debt ratios are set to keep risky loans away, but there are ways around it.
Choosing the Right Lender
If one lender turns you down, you can always apply with another. In fact, getting at least 3 quotes for your loan is the best way to save money. You’ll determine which loan is the best fit for you. It also allows you to get the best loan for your money.
You’ll find that different lenders charge different rates and fees. You may find yourself taking a loan with a slightly higher rate, but lower fees. It all depends on your situation and what you can afford. Take your time finding the loan that works for you – it’s one of the largest investments you’ll make in life.