In today’s low-interest rate environment, with 20% down, you can qualify for a mortgage on a house that is 7-8x your net income (income minus two times all your existing monthly liabilities).
Let us go through the steps banks take to qualify a mortgage loan. We first need to account for all the income and liabilities. For income, W2 income is the easiest to qualify. Bonus income may be considered if there is a history of bonus payments in the past. Rental income for multi-unit properties will be capped at a 75% occupancy rate. For liabilities, all existing structured payments such as a car loan, student loan, HOA fees, alimony, child support, etc. will need to be included. A future mortgage liability will include PITI (Principal, Interest, Property Tax and Insurance). The principal and interest portions are calculated based on the interest rate and the loan period. Banks use a 1.25% property tax rate in California and a small amount like $100 for home insurance.
Banks like to see at least a 20% down payment, which keeps the LTV (Loan to property Value) ratio to 80% or lower. An LTV ratio higher than 80% may require borrowers to carry a PMI (Private Mortgage Insurance). Besides LTV, banks evaluate risk using two metrics: front-end and back-end ratios. A front-end ratio is the future mortgage debt over income. Any value higher than 36-44% indicates high risk and may trigger a more stringent underwriting process, especially for jumbo loans. A back-end ratio is your total liability including mortgage over income and is generally capped at 43%. The income calculation will be adjusted by applying the back-end ratio. A mortgage loan qualified in this way will be such that the total monthly liabilities including PITI do not exceed this adjusted income.
We can express mortgage qualification as a function of your income.
- Monthly Income x 43% Back-end ratio = Monthly liabilities + PITI
We saw that PITI is about 0.5% of your home price (as shown in our blog “Understanding Mortgage Interest.”) Rearrange the equation as follows.
- (Monthly Income – 2 x Monthly liabilities) x 43% Back-end ratio = 0.5% x Home Price
- Net Monthly Income x 86 = Home Price
- Home Price = 7 x Net Annual Income
In today’s low-interest rate environment, with a 20% down payment, you can purchase a home for up to 7-8x your net income, which is your annual income minus two times all your existing monthly liabilities annualized. FinCrafter’s Mortgage Loan Qualification Calculator utilizes the bank criteria discussed in this blog. We compare the income levels needed to qualify for the purchase of a townhome, single family home or a duplex in our blog article “Mortgage Loan Qualification for Different Home Types.”
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