Prequalify home loan, or preapproving yourself is the process of determining how much you may borrow for purchasing your home. The mortgage, along with your downpayment, will determine how much of a home you can afford. Prequlify home loan should be your first step in buying your house so you know what price range you can afford.
For example, if you prequalify home loan and found that you are able to borrow up to $300K, and you have $50K that you wish to use as downpayment, then you should not look for a property that is more than $350K.
Here is a very quick HOW TO on prequalify home loan for yourself before you decide to go out there to look for a house.
There are many things that lenders look at to determine who they want to lend the money to. Among the factors are applicant’s credit history (FICO score), current income and work history, monthly expenses, loan to value ratio, debt to income ratio (which is determined when you prequalify home loan), assets and reservers, etc. A particular lender may set guidelines on all of aforementioned factors and where you stand on one factor (such as your FICO score) may affect other prequalifying factors (such as loan to value ratio). For example, if you have a poor credit score, then the lender may limit you on your loan to value ratio therefore requiring a larger downpayment.
Prequalifying home loan allows you to determine the front ratio and the back ratio. The lender sets limit on these two ratios and therefore from these limits you may derive what the maximum that you are allowed to borrow by lender’s guidelines. Prequalify home loan mainly takes into account your current income, versus what your expenses are.
First, let’s establish some terminologies:
PI = Monthly principal and interest payment for your mortgage, or the so-called monthly mortgage payment.
TI = Monthly tax and home/hazard insurance payment for your property.
PITI = PI + TI = Your total combined monthly payment for your new property.
The front ratio is calculated as such:
Front Ratio = PITI / Gross monthly income
Gross monthly income is basically your annual income divide by 12 months. Do not confuse your growss monthly income with your take home pay each month. This figure usually is larger than your take home pay because gross monthly income is before it is taxed.
Remember, the lender sets limits on what your front ratio and back ratio. As a rule of thumb, your front ratio should not exceed 33% (meaning your PITI should not exceed 1/3 of your gross monthly income) but different lenders have different limits. Knowing this, we can determine what your maximum PITI is and what that means in terms of the amount of mortgage you may borrow. Later on I will show you how you may derive such figure.
The back ratio is calculated as such:
Back Ratio = (PITI + total monthly expenses) / Gross monthly income
Your total monthly expenses are derived from your credit report, and they are usually credit card and auto payments. The lender does not take into account your utility bills, auto insurance, food expenses that do no appear on the credit report. Totaly monthly expenses are only reportable debts that appear on your credit report. However, if you have bad debts that you never paid off, it will show up on your credit report.
As a rule of thumb, your back ratio should not exceed 45% for most lenders, and different lenders may have different back ratio limits. Again, knowing this information, we may determine how much you may borrow.
So what does this all mean to you, and how do you use these formulas to determine how much buying power you have?
Well, let’s look at your front ratio:
Front Ratio = PITI / Gross monthly income
Knowing that your front ratio can not exceed 33%, and knowing your gross monthly income, you can figure out what your maximum mortgage payment can be.
Your maximum PITI = 33% * Gross monthly income
So for example, you make $60K a year, your gross monthly income is $5K, your maximum PITI will be 33% * $5K = $1650/month.
The above example shows that you are able to borrow a loan amount for which the monthly principal and interest payment, tax and insurance payment do not exceed $1650/month. Then, use the following calculator to figure out the price of your home you can afford:
You would then take a current market mortgage interest rate and plug it in the calculator, fill in your downpayment and start guess-estimate your home price, until the total monthly payment comes close to your prequalified $1650/month.