September 30, 2020
4 MINUTE READ
Use these simple ratios to find out how much you can borrow for a mortgage. These ratios are consistent for purchasing a new home or refinancing your existing home loan.
Any time you’re trying to get a home loan it’s important to remember that the lender wants to protect their interest in the home. So these numbers are just the beginning for figuring out how much you can borrow for a home loan.
Other major factors are your credit score and credit report. Taking good care of your credit will help you get better loan terms.
First, you have to compare your monthly mortgage and housing expenses to your monthly gross income. This is the front end ratio.
Take your annual gross income and divide it by twelve to get your monthly gross income.
Add all your housing costs including principal, interest, taxes, and homeowners insurance. Then divide that by your monthly gross income.
This is your front end ratio.
Here’s how you use this ratio to find out how much you can borrow for a mortgage.
Let’s assume you make $75,000 a year. Dividing by 12 gives you a monthly gross income of $6,250.
Most lenders will have an upper limit on the front end ratio that they’re willing to accept. A rule of thumb is around 30%. This could be different depending on the lender.
Take your front end ratio and multiply it by your monthly gross income. In this case it would be 0.30 (30%) x $6,250. This would give you a PITI (principal interest, taxes, insurance) payment of $1,875.
Now you have to make some estimates about how much of the $1,875 would go towards taxes and homeowners insurance.
Use this useful site to determine median property taxes in your state. If you want, you can find property tax numbers at the county level. For the purposes of this article, I’m going to use the median dollar amount for the state of California which is $2,839.
Divide your property tax estimate by 12 to get a dollar figure of $236.
You’ll have to estimate homeowners insurance as well. I’m going to use $800 per year or approximately $67 per month.
So my $1,875 now becomes $1,008 that can go towards principal and interest.
Take your numbers and use this loan amortization calculator to get an estimate of how much you can borrow for a mortgage.
I used the numbers of $1,008 as my payment, 4.5% as my interest rate, and 360 as my number of payments (30 years) and solved for the loan amount. It gave me an estimated loan value of $198,940. This is how much I would be able to borrow for a mortgage.
The interest rate you use will have an impact on how much you can borrow. This is why it’s so important to take good care of your credit score. You want a better rate so you can borrow a little more money but still have a great rate and easy to manage mortgage payment.
The back end ratio also uses your monthly gross income. Only now you’re going to compare all your debt payments to your income. It’s also called the debt to income ratio.
Take all your monthly debt payments including the mortgage and divide them by your monthly gross income.
For example, we’ll keep the same income as above, $75,000 per year or $6,250 a month.
Now let’s assume you have credit card payments of $500 per month and student loan payments of $200 per month and a monthly car payment of $300. That’s another $1,000 a month on top of the $1,875 (PITI) for your mortgage.
Take the total $2,875 and divide it by $6,250 to get your back end ratio of 46%. This is a little high but some lenders might be OK with it.
A good rule of thumb for a back end ratio is 36%. If you knew your lender was ok with 36% you could multiply $6,250 by 36%. This means you would be able to carry a debt load of $2,250 every month without putting you in a tough financial position.
If you wanted to maintain the PITI of $1,875 you would have to decrease your other debt obligations by $625. If that isn’t possible you’ll have to accept a lower allowable monthly PITI of $1,250 ($1,875 – $625). Going with the lower payment would decrease the amount of money you could borrow for your home loan.
If I keep my estimates of $236 a month for taxes and $67 a month for homeowners insurance I’m left with $947 for principal and interest.
Go back to the amortization calculator and keep the 4.5% interest rate over 30 years (n=360). Input $947 for your payment. This shows that you could borrow $186,901 for your mortgage.
This is all simple math that you can do in a few minutes. It’s helpful to do if you need to figure out how much you can borrow for a new mortgage or to crunch some numbers for a home loan refinance.