The 3 pillars of a home buyer’s mortgage qualification are credit, income and assets. In today’s highly regulated lending environment, buyers must qualify for their mortgage loan on all 3 pillars.
With all of the advertising and attention placed on credit scores in the last few years, most buyers know if they have good credit (680+ FICO) or excellent credit (740+ FICO). If a prospective home buyer tells you they have some credit “issues” they most likely do and will need more specialized assistance from a competent lender at that point. Let’s assume here that they have good to excellent credit.
Many home buyers today, especially those in the Millennial Generation do much of their financial planning, bill paying, and shopping online. Therefore, most buyers know how much cash assets they have available and how much they can put down from checking/savings accounts, investment or retirement accounts and/or gift funds. Depending on the loan program your home buyer qualifies for, such as VA loans if they are Military Veterans or Rural Development Loans if they live in USDA eligible rural areas, they may be able to purchase with 100% financing. First time home buyers are able to buy with conventional lending with as little as 3% down and all other primary residence buyers can purchase with as little as 5% down. So as long as you have that base covered, INCOME is the biggest determining factor in how much a buyer will qualify for in their purchase.
The biggest factor in determining a home buyer’s purchase price is the buyer’s debt-to-income (DTI) ratio. The DTI ratio is the total amount of monthly debt they carry to include their new potential housing payment as a percentage of their total monthly gross income (income before taxes and deductions for salaried and hourly buyers) and Adjusted Gross Income (AGI) after expenses for self-employed buyers and independent contractors. Lenders use the total housing payment including Principal, Interest, Taxes, Insurance, and Association dues, if applicable (PITIA) when determining max DTI. Existing debts are calculated using the minimum payments on a buyer’s credit report.
General Debt-to-Income guidelines for Conventional, VA, FHA, and USDA loans. *Please note: the information provided below are general concepts and guidelines for each loan program and the actual characteristics available to your home buyer may be different based on their specific credit profile and qualifications.
- Conventional (loans underwritten and approved under Fannie Mae and Freddie Mac guidelines): max 50% total monthly debt to include proposed PITIA.
- VA (Veterans Administration for qualified Veterans): roughly 50% but depending on strength of buyers credit and assets, can go as high as 60-70% debt to income ratio. For initial pre-qualification, always go with 50% to be conservative.
- FHA (Federal Housing Administration): use 50% DTI for this one.
- USDA (Dept of Agriculture Rural Development Loan Program): 43% for total DTI and separately 32% max for PITIA as a percentage of the home buyer’s total gross monthly income. MUST meet both requirements.
Through my experience, your home buyer’s monthly payment comfort level is far more important than the maximum monthly payment they will qualify for based on DTI. A total of 50% debt-to-income ratio is fairly high and the comfort level of most buyers is usually lower. As long as they qualify for at least the amount they want to spend each month, then you’ll know how much cushion you have above that figure if they find the right property and the payment will exceed their comfort level. Good lenders will always ask your client the housing payment they are most comfortable with before determining the maximum qualifying payment to understand where they prefer to keep the total housing payment.
Here is the basic calculation to determine debt-to-income ratio:
- Gross Monthly Income X 50% (or divide by 2) = Maximum Total Monthly Debt.
- Max Total Monthly Debt – Minimum monthly credit card payment(s) – Monthly auto loan or installment loan payment(s) – Monthly student loan payment(s) = Maximum Total Housing Payment (Principal, Interest, Taxes, Insurance, and Association Dues PITI-A).
For example, if a buyer earns a gross salary of $6,000 per month, has an auto loan payment of $350 per month and minimum credit card payments of $50 per month, then their max PITI-A is calculated like this:
- $6000 X 50% = $3000 Max Total Monthly Debt Payments
- $3000 – $350 – $50 = $2600 Max Total Housing Payment
It is really that simple. If you are able to obtain your buyer’s current approx income and debt information through the relationship building process, you can help them understand what their approximate max monthly payment will be when they are ready to take the next step and get pre-approved with a mortgage lender.
The next step is to calculate the purchase price that corresponds with the maximum monthly housing payment depending on your buyers loan program and down payment. See the article Calculating the Estimated Purchase Price for Your Home Buyers for more information.
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