Factors That Determine How Much You Can Borrow for a Home Loan

by Elizabeth Rosen, Contributor

There are many factors which impact the size of your mortgage loan, most of which are within your control. Your income, savings, and credit history will be analyzed by mortgage lenders to calculating how much you can afford. Ideally, you’ve been putting money aside for a while now to cover the costs of getting a mortgage loan, and making sure your finances are in order.

READ:  Should I Keep Paying on My Underwater Mortgage?

Here are some of the most important items that mortgage lenders will consider when determining whether you are a good candidate for a home loan.

DOWN PAYMENT

As we said before, your down payment is the first lump sum of cash that you must “put down” towards paying for the property. The down payment is expressed as a percentage of the home’s purchase price. For example, a 10% down payment on a $200,000 house would be equal to $20,000. Therefore, if you put 10% down (by paying $20,000 upfront) that leaves you with a principal mortgage balance of $180,000.

Most home loans require a down payment that’s anywhere from 3.5% to 20% of the home’s purchase price. Putting 20% down will likely get you a large mortgage loan (i.e. an expensive house) with a low interest rate. However, there are also many options for to homebuyers who want to put less money down.

When you make a down payment, you are essentially putting equity into the home (also called “home equity”). If you can put a large amount of home equity into the property upfront — by providing a large down payment — it means you have more “skin in the game” which lessens the lender’s exposure to risk. In return, the lender is more likely to offer you a bigger mortgage loan and/or a lower interest rate.

INFOGRAPHIC:  What Your Favorite TV Homes Are Worth

This is because the mortgage lender wants to ensure that there’s enough home equity in the property (which they will assume as collateral for the purpose of your loan) to protect them in case you default on the mortgage or go into foreclosure.

However, you should remember that lenders will also look at your monthly income and credit history to determine what size loan you can get. You can still obtain a home loan for less than 20% down — as long as your income and credit are satisfactory — but the interest rates will be higher and you’ll probably have to pay for mortgage insurance.

CREDIT RATING

When you go to apply for a home loan, the mortgage lender will request your credit score because it is a good indicator of your risk as a borrower. Your credit rating is a representation of your financial history — it reflects how you have handled credit obligations in the past, thus allowing lenders to estimate your probable future performance.

Mortgage lenders use credit scores to assess their risk if they choose to lend you money. Your credit history portrays your reliability when it comes to fulfilling your debt obligations and gives lenders an idea of how responsible you are as a borrower.

Each mortgage lender has different credit score requirements, so it’s a good idea to shop around. If you have bad credit, you will be viewed as high-risk borrower who is more likely default on a loan.  And while there is no standard “cut-off” number, you’ll probably need a credit score of at least 740 in order to qualify for a conventional mortgage loan with a decent interest rate.

In general, the higher your credit rating is, the lower your mortgage rate will be. Having weak credit doesn’t mean you won’t get a mortgage loan at all, so don’t despair! But if you do secure a loan, it will most likely come with a higher interest rate and you may be required to make a sizeable down payment.

READ:  I'm Moving in 2 Weeks, But I Own My Home. What Do I Do?

Since the average home loan is hundreds of thousands of dollars, even a single percentage point difference in your mortgage rate can add up to a lot of money in the end. According to Consumer Reports, “Over the life of a $150,000 [mortgage] loan, the people with the best credit scores may pay roughly $138,000 less than those with the worst.”

As you can see, the connection between your credit and mortgage is important — and it means you’ll have to be wise about your financial decisions so that your ability to get approved for a home loan isn’t jeopardized.

DEBT-TO-INCOME RATIOS

In order to figure out how much house you can afford, you will need to understand “debt-to-income ratios.” These ratios compare your monthly income (i.e. wages) to your monthly debt obligations (e.g., housing costs, student loans, car loans, etc.). Your debt-to-income ratios help mortgage lenders assess your financial strength, and it prevents potential borrowers from getting a home/loan they can’t really afford.

Quite simply, the more income you earn and the less debt you owe, the bigger the loan you can get. Most lenders have a standard cut-off point that requires your monthly debt obligations to be limited to a certain percentage of your income.

There are two types of debt-to-income ratios that you need to be familiar with: the “front-end ratio” and the “back-end ratio.” Both of these ratios are based on your gross income, which is your annual income before taxes are taken out.

The front-end ratio (also called the “housing expenses ratio”) is used to show how much of your income would go towards paying the mortgage each month. The front-end ratio compares your basic monthly housing costs (including mortgage payments, condo fees, homeowners insurance, and property taxes) to your monthly gross income. Most lenders will require your monthly housing costs to be limited to 28% of your monthly income before you can be approved for a mortgage loan.

READ: 5 Questions to Answer Before Moving in Together

The back-end ratio (also called the “total debt-to-income ratio” or the “total obligations-to-income ratio”) is used to show how much of your gross income would go towards all of your debt obligations. Debt obligations include your housing costs (above) plus any car loans, student loans, credit card balances, child support, and alimony. Most mortgage lenders will require your total monthly debt obligations to be restricted to 36% of your monthly income before you can be approved for a mortgage loan.

The Bottom Line

As you can see, the type of mortgage loan you obtain is influenced by several factors, including your current financial position, your credit history, and the size of your down payment. Those factors will impact the size of your loan as well as your mortgage rate.

It is best to plan ahead and establish a budget so you can work on saving up for the costs of home buying and homeownership. Be sure to check on your credit score (if you haven’t already) and get to work on improving it. Also have your documentation (e.g., financial records, pay stubs, tax returns, etc.) prepared to show the mortgage lender when you go to apply for a loan.

You can even go a step further and ask the lender to pre-qualify or pre-approve you for a certain amount, which gives you an idea of what you can afford. Additionally, pre-qualification and/or pre-approval make you a more attractive homebuyer and give you some negotiating power with sellers.

Shop around and get quotes from various lenders so that you find the right mortgage loan for you and your budget. Make sure you do the proper research and understand the loan terms before you sign anything. You can never be too careful when making such a big financial decision!