When evaluating whether to approve your mortgage application, lenders take your salary and mortgage amount into account not through a direct ratio but as part of other ratios between total monthly debt payments, including mortgage and housing-related payments, and income. With some basic information on these ratios, you can make an informed assessment as to whether a mortgage amount or terms are an affordable or wise financial decision.
How Lenders Evaluate Loans and Mortgages
Scrupulous lenders only approve loans and mortgages that borrowers can afford to pay back. Since your credit score tells lenders more about your payment history than whether your income is enough to pay for your debt, lenders also use a borrower's debt-to-income ratio to determine whether the amount and terms of the mortgage are affordable. Even credit card companies are now required by the U.S. Federal Reserve to consider your total debt and income or assets using "a reasonable estimate" or "statistically sound models" before issuing you a credit card.
Total Debt-to-Income or Back-End Ratio
Your total debt-to-income or "back-end" ratio is the total of all your monthly debt payments divided by your gross (pre-tax) income. Debt payments include the proposed mortgage payment, as well as student loan and car loan payments and your income includes not just salary, but also side-businesses or rental properties. For example, if you also pay £162 in car loans and £162 in student loans and the payments on the monthly mortgage and other housing costs on the terms that you're seeking are £650, then your total "recurring monthly debt" is £975. Similarly, if you earn £27,300 a year or £2,275 a month before taxes and you receive £325 a month in rent from another property, then your total monthly income is £2,600. This means that your total debt to income ratio is £975 divided by £2,600 or 0.375, that is, 37.5% of your gross monthly income goes toward paying debt.
Housing Expense or Front-End Ratio
Lenders may also use a "housing expense" or "front-end ratio" when evaluating your mortgage or loan, by totalling your proposed monthly mortgage payments, property taxes, homeowners' insurance and homeowners' association dues (if any) dividing this by your monthly gross income. Many lenders use a 0.28 maximum ratio as a rule of thumb for whether the mortgage payment is affordable.
Is Your Mortgage Affordable?
Lenders usually don't approve loans or mortgages when they tip total debt-to-income ratio past 0.36 or do so at higher rates. Although the Federal Housing Administration or FHA secures loans with total debt-to-income ratios up to 0.41, few lenders approve loans on those terms and many cautious lenders don't lend on terms that tip ratios pas 0.31 or even 0.28. The federal Home Affordable Modification Program (HAMP) tries to help homeowners with mortgages and front-end ratios of more than 0.31 modify the terms of their mortgage to an affordable level (below the 0.31 ratio).
Making Your Mortgage Affordable
As the mortgage meltdown taught borrowers, just because you're approved for a loan or mortgage doesn't mean it's a wise financial decision to take it. You can lower your monthly mortgage payment amount by reducing the mortgage amount, finding a lower mortgage rate or extending the length of time to pay back the loan, although this last option will increase the total interest you'll pay over the life of the loan. The best time to take these steps to make your mortgage affordable is before you agree to its terms, since refinancing or modifying those terms once you have the mortgage has become increasingly difficult given the waves of homeowners struggling to pay their mortgages after 2008 who are requesting modifications.
- Bankrate: Debt-to-Income Ratio Important as Credit Score
- Bankrate: Borrowers looking to score mortgage modification
- Wall Street Journal: Look Who's Peeking at Your Paycheck
- Harvard University Joint Center for Housing Studies: Homeownership, State of the Nation's Housing 2010
- Making Home Affordable: Making Home Affordable FAQs