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Determining How Much You Can Afford to Borrow

Stamp printed on the approved loan application approved.

How can you be certain how much you can afford when applying for a loan? Many home shoppers find a quick fix answer on websites that provide an online calculator. Simply entering your monthly income, expenses and what you believe to be your credit score in a computer program won’t accurately predict what a specific lender will actually agree to lend you. More important, it won’t give you insights into the often flexible, case-by-case factors that lenders can use in order to get your loan application approved.

Here’s what really matters to lenders and how you can more accurately foresee whether or not you’ll qualify for a given loan amount.

1. Ratios are important: Every mortgage lender uses debt-to-income (DTI) ratios to judge your financial capability to repay a loan. It is used to measure your gross monthly household income and compare it to two types of debt: The money you spend each month on core housing-related expenses combined and the amount you spend on non-housing debts, such as credit cards, auto loans, student loans, etc.

2. Your Housing Ratio:

How much will your top housing-related costs be per month and what percentage of your income will they represent?

These housing costs include

  • Principal, interest, property taxes and hazard insurance on the loan you’re applying for
  • Homeowners association, condominium or cooperative fees that you are required to pay
  • Any additional fees required for your mortgage or property, such as flood insurance or mortgage insurance premiums.

3. Your total debt ratio: This ratio is the most significant. A lender will take your total housing expense and add all other recurring debt payments that you have, including credit cards, auto loans or leases, personal installment loans, student loans, child support and alimony payments.

4. Loan types matter a lot: For majority of new buyers, the type of mortgage they choose will have a large impact on what they can afford. There are four major types of mortgages:

  • Conventional: loans intended to be sold to Fannie Mae or Freddie Mac, the giant mortgage investment companies. These loans generally require higher down payments and stricter underwriting standards than government agency-backed loans.
  • FHA: Federal Housing Administration-insured loans are designed for first-time buyers and those with less-than-perfect credit histories.
  • VA: Provided by the U.S. Department of Veteran Affairs, these guaranteed mortgages are reserved for active duty and retired military personnel.
  • USDA: Also called a Rural Development Loan, these mortgages are intended to serve buyers in rural and small towns, where credit availability can be tight.

For more details on loan tips along with mathematical examples, click here.