Mortgage-Refinance Loan Measurment 101 -- Evaluate Your Own Ability to Pay

By Mark Barness

We live in a society where people are losing their homes at an alarmingly high rate. There are several reasons for this, but one could certainly be avoided -- buying a house that creates a loan that is too large for you to handle. This article will examine how to decide your loan size -- whether you are purchasing or refinancing. We'll look at this issue from the point of view of lenders and from the standpoint of what is actually best for you.

In a conventional, conforming loan -- one in which you have good credit and good job history -- a lender will look at what he calls "debt-to-income ratio." Many mortgage brokers refer to it as DR (debt ratio). They also break it into two categories -- front end ratio and back end ratio.
A front end debt ratio calculates your gross monthly income against your new house payment. Conventional lenders want this number to be at 28 percent or less. So, if you make $3,500 each month in gross income (before taxes and other withdrawals), just take this number and divide by 28 percent. This new number is $980.00, which is the number the lender will use as your front end ratio. So in the lender's mind, you can afford a house payment of $980.00 or less.

Remember, though, this is only half of the equation. Now, the lender will look at your overall debt scenario. When calculating your back end debt ratio, the lender takes your new mortgage and all other monthly credit debts -- car payments, credit card payments, other loans, cell phones, etc. Items like insurance and utilities are not included. Conventional, conforming lenders want this ratio to be at 36 percent or less.

So, to calculate your back end or overall debt-to-income ratio, take your gross monthly income and divide by 36 percent. Again, let's assume you make $3,500 monthly. When divided by 36 percent, you get $1,225.00. Now, add up all your monthly minimum payments, plus your new house payment, and this new number needs to be less than $1,225.00. So, if you have very little debt, you can afford to go all the way to the $980.00 for a new mortgage. If you have a couple of cars, several credit cards and a cell phone, you'll likely have to get much less house.

Now, these ratios are very conservative. In most cases, lenders will allow you to break one or both of these guidelines, based on other factors -- things like A+ credit, good liquid assets or a large down payment.
Or, you may need a loan program that is non-conforming. This would involve a lender who increases these ratios as high as 50 percent, meaning your debt can be half of your gross monthly income. Lenders, you see, want to make loans. That's why they are so rich, because they are doing trillions of dollars in loans each year, and getting back even more in interest payments.

In order to assure yourself of getting a loan that you can afford, you should qualify yourself. It's important to remember that when calculating debt to income ratios, lenders don't take many important factors into account. For example, they allow you to use gross income -- instead of net income. We pay our bills with our net, not our gross. When deciding what you can qualify for, consider your net income.

In other words, add up all your debts and look at the money you have after taxes, retirement, savings, other investments, etc. Also, account for debts lenders do not, such as insurance, groceries, utilities, the probability that taxes on your home will go up, clothing, and spending money for fun and hobbies. After all, you want having a home to add to your life -- not make it more difficult. Lenders leave this part out