How does a Mortgage Pre-approval work?

Many of you have heard about “getting pre-approved” with a lender.  It should be pretty obvious what this means, but what most people don’t know is how an approval is determined.  You might be surprised to find out that mortgage borrowers are not approved for loan amounts, but more specifically- they are approved for monthly mortgage payments.  Let me explain further…

The amount that a borrower gets approved to borrow is extrapolated from their maximum allowable monthly payment.

The key number in a mortgage loan approval is called the “debt to income ratio”.  This number is found by dividing the “GROSS MONTHLY QUALIFYING” income by the minimum monthly payments on all debts.  Many mortgages will only allow a borrower to have up to 45% DTI.  This can also be described as: many mortgages will only allow a borrower to owe 45% of their gross monthly income to debts (including the total mortgage payment).

For simple math, if a person has $10,000.00 of monthly qualifying income, they would not be approved to carry debts that resulted in monthly payments that exceeded $4,500.00 per month (45% of the gross).  And this $4,500 includes all payments on all debts, plus the full PITI +HOA and PMI monthly payment on a potential mortgage.  But think about this- since a borrower is only approved for a monthly payment, as rates fluctuate, the amount they are approved to borrow expands and contracts in direct correlation.  Generally, a change in 1% of mortgage rate will result in a 10% change in purchase price.

Believe it or not, FHA loans will generally allow DTI’s up to 55%!  Now I’m glad that this is true, because in a lot of cases someone’s qualifying income can be vastly different to their true-life income.

As far as personal financial sustainability, I would recommend that people should be trying to operate at or below 30% of true DTI.  This means that if you are actually making $5,000 per month, your total monthly debt target including housing debt should be right around $1,500.  My experience shows me that this level will allow you to devote appropriate levels to short term and long term savings.  If you aren’t at this level, please contact me and we can brainstorm about ways to point you in the right direction.

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