Mortgage Formulas For Borrowers

Most people experience only the yes or no of borrowing. Either you’re approved for the loan or you’re not. Behind the scenes, there are a lot of calculations that determine whether you receive an approval or a denial. We don’t expect you to remember all of the formulas but try to realize that they do exist and are applied across the board to everyone who applies for a loan, mortgage, rental, or lease.

Most lenders won’t disclose the exact formulas they use for determining loan eligibility, but some will. Before applying for any type of credit or loan, it doesn’t hurt to ask the lender what criteria are used to determine eligibility. For an example, a lender might state that it’s looking for a maximum ratio of credit card balance-to-credit limits of no more than 20%. That means the total amount you owe on all of your credit cards combined can’t exceed 20% of the total credit limits. Add up your credit card balances and limits. If you owe more than 20% of the total credit limits, pay off some of the cards before applying for the loan.

In addition to the percentage of credit card use, most lenders also use formulas to determine the Loan-to-Value RatioIncome Ratio, and Debt Ratio.  Loan-To-Value Ratio is simply the maximum percentage a bank will lend toward a house. In most cases the loan-to-value ratio is 80 – 90%. The inverse to that ratio is your down payment. If a bank is willing to lend 80% of the home’s value, then you’ll probably be required to come up with a down payment of 20%.  If the loan-to-value ratio is 90%, you might be able to squeeze by with only a 10% down payment.

Turning now to your finances, the lender will look at the income ratio. The income ratio is the maximum amount of your monthly gross income that the bank will allow to be used for the monthly mortgage payment. In most cases the monthly mortgage payment will include principal and interest on the loan plus property taxes. The income ratio is a flat percentage that most lenders should disclose if you ask. Let’s say the lender’s maximum income ratio is 26% and you earn $8,000 per month. Multiply your gross monthly income by the income ratio. $8,000 x .26 = $2,080. If the proposed monthly mortgage payment is more than $2,080, you probably won’t be approved for the loan.

Lenders also consider your total debt ratio. The debt ratio is a little more complicated than the income ratio because it takes into consideration all of your monthly expenses including credit cards, car loan payment, student loans, etc. Most lenders utilize a debt ratio formula of around 35%. Let’s say the proposed monthly mortgage payment is $912 and your total other expenses are $1,500. Your total proposed monthly expenses would be $2,412. In our example, the lender’s maximum allowable debt ratio is 36%. Divide the total proposed expenses by 36%. $2,412 / .36 = $6,700. Your gross monthly income must be at least $6,700 in order to move to the next step of the loan approval process.

Lenders may also use a hybrid formula derived from the debt ratio. What will your total debt ratio be if you’re approved for the loan? In the above examples, your monthly gross income is $8,000 and your total proposed monthly expenses if you receive the loan would be $2,412. Divide your total expenses by your gross monthly income. In this case, $2,412 / $8.000 = 30.15%.  Since the bank’s maximum debt ratio is 36%, you fall well within the criteria for the loan.

When applying for loans or any type of credit, always think minimum, not maximum. If the lender’s maximum ratio of credit card balances to credit limits is 20%, try to get your balances well below 20%. If the lender’s maximum debt ratio is 36%, try to reduce your other monthly expenses so your debt ratio is much lower than 36%. The closer you are to the lender’s maximum acceptable percentages, the less chance you have of being approved.

On an important sidenote that we must include, Credit Karma offers amazing free credit services. After logging into your account you can instantly see your credit card usage. There’s also a cool credit simulator tool. It shows how your credit score will be affected if you open a new account, pay off a credit card, lower your total credit card balances, etc. In some cases, cutting your credit card balances in half might raise your credit score by 50 points or more. We are not associated with Credit Karma in any way, but we do highly recommend its free credit services.

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