How to Become Mortgage Ready-Part 4: Check Your Liabilities

First Time Home Buyers in Orange County Calif are finding that the number of available homes for sale has shrunk to the point where making an offer and getting it accepted is a competition.  As in any competition, the strongest competitor will almost always win.  In the case of purchasing a home,you become a strong contender by making sure that your financing is in place before you make that offer.

The process of securing financing is not as simple as filling out an application and 5 minutes later receiving an answer.  There are significant steps involved in becoming mortgage ready and this is part four:

Check Your Liabilities!

In part 1 of this series I described how the first thing a lender will do after taking a full and complete credit application is to check your credit report to determine your FICO score.  Lenders also use your credit report to assess your liabilities, or the amount of money you owe.  Then this information is used to calculate your debt to income ratios.

What are debt to income ratios?

Simply put, a debt to income ratio divides all of your monthly payments by your qualifying income to arrive at a measurement that tells us how much of your monthly income is being used to pay off your debt (liabilities).

There are two sets of ratios:

Ratio one is commonly referred to as the “front end ratio” or “housing ratio” and simply measures the intended mortgage payment against your qualifying income.  Lenders do not like to see this ratio exceed 31%-33% but often times will approve a loan with higher ratios depending upon the loan program and the borrower’s unique circumstances.

Ratio two is commonly referred to as the “back end ratio” or "total ratio" and it includes all of the housing expenses in the front end ratio plus all of the payments you make on your debt every month.  Lenders do not like to see this ratio exceed 43% - 45% but often times will approve a loan with higher ratios depending upon the loan program and the borrower’s unique circumstances.

So let’s look at two different examples:

John, a single man, is a teacher earning salaried income of $84,000 per year, or $7,000 per month.  John is conservative and has very little debt – just a car payment of $300 per month.

John wants to buy a $400,000 home and wants to put 20% down ($80,000).

His ratio’s look like this:

In this example, John is able to qualify for the best loan programs and interest rates available due to his very low debt to income ratios, and purchases the home he desires.

Now let’s look at a different example:

Sam and Ellen are a married couple who have not lived frugally and are now working hard to pay off debt accumulated over the last few years.  Together they earn salaried income of $144,000 annually, or $12,000 per month.  They have recently decided they would like to purchase a home – we’ll use the same $400,000 threshhold as in example 1 – and can put down only $13,500.

With two car loans totaling $1,400 in payments, $100,000 student loans requiring $500 in payments and credit card debt of $100,000 requiring $2,500 month in payments, and very little money in savings, their numbers are very different then example 1.

Their ratio’s look like this:

Although this fictional couple earn a significant amount of income, and would appear to have sufficient income to make this monthly mortgage payment, they have virtually eliminated their ability to purchase the home they desire due to the high amount of debt they are carrying.

When clients come to me with this situation I will meet with them to help create a plan to reduce their debt to a level that fits within the purchase price they wish to buy.  There is no judgement here...just analyzing the numbers to figure out how to best serve my clients' goals.

So as you can see, your credit report is used for much more then just determining your FICO score – your credit report gives your lender a way to calculate how much those liabilities are costing you each month, and in turn helps us determine how much house you can qualify for.

The criteria for qualifying for a mortgage is complex, so it is important that you contact a loan professional to obtain a pre-approval before you make that all-important offer on your dream home.

For more information and a no-pressure conversation about your ability to qualify for a home loan, give me a call at (714) 403-2603 or send an email message to Linda@LindaOnLending.com.