How do mortgage lenders decide how much you can borrow?

Plus: What you need to know about the affordability assessment

How do mortgage lenders decide how much you can borrow?

Buying a home is usually one of the biggest financial decisions you will make in your life. Figuring out how much you can afford to borrow often depends on multiple factors. It is good to enter this process with a thorough understanding of your own finances, which includes where your priorities lie—as well as what lenders may look for. Here is a simple guide to show you how mortgage lenders decide how much you can borrow.

Gross income

Before deciding how much you can borrow, mortgage lenders will look at your gross income. This is the level of income you earn before taxes and other obligations. Generally, gross income is your base salary, as well as any extra income, which can include self-employment earnings, part-time earnings, disability, alimony, child support, and social security benefits.

Front-end ratio

The front-end ratio, otherwise called the mortgage-to-income ratio, is determined by your gross income. The front-end ratio is the percentage of your yearly gross income that you are able to pay toward your mortgage every month. The amount of money that comprises your monthly mortgage payment is made up of four components, which are known as PITI. PITI stands for principal, interest, taxes, and insurance. That insurance, if required at all for your mortgage, includes both private mortgage insurance and property insurance.

Generally, the front-end ratio based on PITI should not be more than 28% of your gross income. There are lenders, however, that will allow you to exceed 30%, and some lenders will even allow you to go above 40%.

Back-end ratio

Back-end ratio is also called debt-to-income ratio, or DTI. Your DTI calculates the percentage of your gross income that is needed to pay off your debts. Those debts include child support, credit card payments, car loans, student loans, and any other outstanding loans. An example of a back-end ratio breaks down like this: if you earn $4,000 each month and you pay $2,000 each month in debt services, your back-end ratio is 50%, i.e., half of your income each month goes to pay your debt.

It is important to note, however, that a 50% back-end ratio will not get you your dream home. Lenders typically suggest that your back-end ratio not be more than 43% of your gross income. If you want to calculate your max. monthly debt based on the back-end ratio, you can multiply your gross income by 0.43, then divide that number by 12, for 12 months.

Credit score

When deciding how much you can borrow, mortgage lenders will look at both sides of the coin: first, your income, and second, your debt. To better determine the level of risk of a prospective homebuyer, mortgage lenders have developed a formula. While it varies, the formula is usually determined by using your credit score. If you have a low credit score, for instance, you can expect to pay a higher interest rate, or an annual percentage rate (APR), on your loan. You will definitely want to pay attention to your credit reports if you are hoping to purchase a property sooner than later.

Repeat: keep a close eye on your credit reports, because if there are inaccuracies or inconsistencies, you will have to allow the time to have them removed. You do not want to get yourself in a position to miss out on the perfect home because of something that is not within your control.

Affordability assessment

When deciding how much money to lend to you, mortgage lenders will also put you through an affordability assessment. Basically, an affordability assessment is when mortgage lenders look at the amount of money you usually earn each month versus how much you spend each month. What you spend your money on is also of interest to mortgage lenders. The reason for this is that expenses such as, say, a gym membership can be easily cut back. Other expenses, meanwhile, are less flexible. Childcare costs, for example, are likely to be more fixed.

During an affordability assessment, a mortgage lender is likely to ask about income, which can include regular income from paid work, income from other sources, and any benefits that you get. Lenders will also ask about outgoings, such as grocery and transport costs, spending on leisurely activities, regular bills like electricity and gas, and credit card bills, student loans, and other debt repayments.  Mortgage lenders will then verify what you have reported with recent wage slips and bank statements.

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