Do You Know How to Increase Your Purchase Power?
Estimated reading time: 4 minutes
Prospective homebuyers are often asked, “What’s your price range?” Unless you are paying cash, that answer depends on multiple factors, with credit score, income, and debt-to-income (DTI) ratio being the most important ones. While the best and most expedient way to determine your price range for a home that you can afford is to obtain a pre-approval from a lender, this article will help explain how some of those factors come into play.
Your Debt-to-Income (DTI) ratio is one of the most critical factors in qualifying for a home loan. It determines what type of mortgage you’re eligible for and it also determines how much house you can afford. Simply put, a debt-to-income ratio is roughly calculated by dividing the total of your monthly debt amounts by the amount of your monthly income. Ideally, lenders like to see no single monthly debt payment higher than 28% of your total monthly income and a total combined DTI of less than 36%. It’s rare to qualify for a loan with a DTI as high as 50%, and most of the time, 43% is the highest DTI a lender is willing to consider because that is the maximum limit set by the federal government to be considered for an FHA home loan.
Any of these are considered types of debt, and they will appear in a credit report along with the monthly minimum payments, late payments, and outstanding balances.
- Car payments
- Student loans
- Credit cards
- Child support or alimony
- Personal loans
- Monthly installment loans
Note: Living expenses such as gas, food, insurance, phone, internet, and more will also be considered when determining a loan amount that does not exceed 100% of your income. Be prepared to know and discuss your average monthly living expenses with a lender.
The most common types of income that count toward a home loan application include:
- Employment (full-time & part-time)
- Self-employment and freelance work
- Tips, bonuses, and commissions reported by an employer
- Child support or alimony received
- Retirement, Pension, Annuity
- Social Security or Disability
It’s also important to note that employment income of any kind must be verifiable by a W-2 or a 1099 statement.
While no definitive list works with all lenders, a more complete of possible income types can be found in this article by The Mortgage Reports.
Your credit score is determined by several factors, including the number of open accounts, the outstanding balance compared to the credit offered, the number of late payments, and even the number of inquiries to your credit. You may wish to read more about how your credit is calculated in “How Your Credit Score Determines Mortgage Options“, but here is a brief summary:
- If your credit score is 500 or more, obtaining an FHA loan is possible.
- If the score is at least 620, you are in the range for a conventional loan, which typically requires a 20% down payment but can offer several loan options.
- If you need to borrow over $726,200 (referred to as a “jumbo loan”), a minimum credit score of 700 is required.
While these values may fluctuate from year to year and state to state, the difference is usually negligible. The credit score used by lenders will be the middle score from the three credit reporting agencies, and if there are two borrowers, the average of their two middle scores is used to qualify for a loan. Other factors in determining your purchase power include:
Loan to Value (LTV)
This is a ratio between a desired loan amount and the expected value of a property. Lenders use this ratio to assess the lending risk and to determine if mortgage insurance will be required. If the LTV of a property is more than 80%, you will most likely need to pay mortgage insurance and have your annual property taxes (prorated on a monthly basis) included in the monthly mortgage payments to the lender.
Down Payment
How much can you spend toward the initial purchase of your new home? The more you can contribute at closing, the more likely you will qualify for a home loan and/or receive more favorable loan terms. The higher the down payment, the lower your loan amount will be. Since the loan amount will have a positive impact on your DTI and LTV ratios, the higher down payment will improve your chances of approval.
If you don’t know your purchase power, you can quickly get an estimate with a purchase power calculator. For better results and your peace of mind, a mortgage loan specialist can establish a more accurate price range. I work with excellent, knowledgeable mortgage lenders, and I will be happy to recommend the ones who may best fit your situation. Let me know if you would like to know more closely what your purchase power may be.