Shopping for a mortgage means more than finding the best interest rate. Before you start, you should figure out just how much money a lender will let you borrow. Once you know the amount of the loan you can get, you can figure out how much home you can afford by adding the amount of your saved down payment to the loan.
Figuring out how much money a lender will lend you depends on many factors. We review them for you below.
What’s Your Credit Score?
The very first thing lenders look at is your credit score. The higher the credit score, the lower your risk of default. This doesn’t automatically mean you’ll be able to borrow more money, but it’s a good start. Each loan program has minimum credit score guidelines, but the higher your credit score beyond that minimum, the higher your likelihood of getting the mortgage amount you want/need.
What’s Your Debt Ratio?
The next most important factor is your debt ratio. This lets lenders know how much of your monthly income is spoken for and how likely you are to make your mortgage payments. The higher your DTI, the harder it might be for you to make your payments on time. This could prompt a lender to give you a lower loan amount just to lower the risk of default.
Each loan program has its own required debt ratios, but again, the lower your ratios are in comparison to the maximum allowed, the better off you’ll be. Lenders look at both your housing ratio and your total debt ratio. Your housing ratio is the new mortgage payment’s ratio compared to your income and your total debt ratio is all of your debts compared to your income. The lower both numbers are, the better off you are in getting the loan you need.
What Type of Loan do you Want?
Next, you have to determine if you want a fixed rate loan or an ARM loan. This could make a difference in how much mortgage a lender gives you. ARM loans tend to provide a little more flexibility in terms of figuring out how much you can borrow because they have a lower interest rate, at least at first. If you need to increase your purchasing power, an ARM may be the answer that you need.
If you want the fixed rate loan for the predictability of having the same interest rate, you’ll likely have a higher interest rate. But, you get the benefit of having the same rate for the entire loan’s term, which can make it easier to stay on track with your budget.
If your debt ratio is close to the maximum, you may want to consider an ARM and then refinance before the rate adjusts. Generally, you have 3 years at the least to refinance your loan before it adjusts. This gives you time to pay off some debts, reduce your debt ratio, and secure a lower fixed rate loan.
Consider Your Compensating Factors Too
Lenders look at more than just your credit score and debt ratio to determine how much they will lend you. They look at things like:
- Employment history – Do you have a stable employment history or do you jump from job to job? The more jobs you have in the last few years, the higher risk you pose. This could play a role in how much the lender is comfortable lending you.
- Income history – Does your income steadily increase over time or does it go in waves? Lenders like to see steadily increasing income, not decreasing income. If you work in an industry that is seasonal or you work on commission, your lender may take a 2-year average of your income to account for those ups and downs.
- Credit history – Outside of your credit score, lenders look at your actual credit history to see what financial habits you have. Do you have collections or do you make your payments late? Lenders look at these things to see how reliable you are because even with a ‘good’ credit score, you could have a questionable credit history going back over the last couple of years. The lender will take this into consideration.
As you can see, how much mortgage a lender approves you for depends on many factors. There isn’t a one-size-fits-all approach to the matter. The best thing to do is make your application look as attractive as possible. Starting as soon as you know you are going to buy a house in the future, start working on your credit score and debt ratio. Also make sure your income and employment are as steady as possible and that you have as large of a down payment as possible to increase your chances of getting approved.