Lenders determine whether you can afford mortgage payments by evaluating your credit risk and overall financial condition. Generally, they’ll want to make sure that your debt-to-income ratio is low enough that you can afford to repay them.
How to Determine Your Debt-to-Income Ratio
Mortgage lenders want to know that no more than 28 percent of your income will go toward repayment of your loan. Simply multiply your gross monthly salary by 0.28 to figure out how much house you can afford.
You can determine your own debt-to-income ratio by adding up all of your monthly obligations (including your current mortgage or rent payments) and dividing that number by your gross monthly income.
If you pay $1,000 for a mortgage, $500 in bills and $500 in other expenses, your monthly obligations are $2,000. Assuming your gross monthly income is $6,000 (remember, that’s before taxes), then you’ll divide 2,000 by 6,000.
In this case, your debt-to-income ratio is 33 percent.
How Lenders Assess Your Creditworthiness
For the most part, lending institutions use the 5 Cs to assess your creditworthiness. They take into account:
- Credit history. Have you always paid your bills on time? Have you ever defaulted on a loan or declared bankruptcy? These and other factors provide lenders with your credit score, which shows how fiscally responsible you have been in the past. All legitimate lenders will check your credit rating before considering your application.
- Capacity. Based on your employment history and past levels of income, lenders can get an idea of your ability to repay a large loan. Underwriters use your debt-to-income ratio to evaluate your credit risk and determine whether you have the capacity to pay back a mortgage loan.
- Collateral. When you purchase a home, it’s through a secured loan – and the collateral is your home. If you fail to make payments on your loan, the home becomes the lender’s property.
- Capital. Mortgage lenders view capital as anything you could rely on to make payments if you experienced a sudden loss of income. Your capital consists of investments, savings accounts, retirement accounts and other assets that you can quickly liquidate.
- Conditions. Conditions of a loan involve how you intend to spend the money you receive from a loan. In the case of a mortgage loan, lenders will want to ensure you are purchasing a home by talking to your Realtor® and possibly inspecting the home.