When signing out a mortgage, both borrowers and lenders have a mutual interest in limiting the loan to an amount the borrower can pay back. Borrowers do not want to lose their house to foreclosure, and banks do not want to recklessly lend money to people who will not be able to pay for the mortgage. So they have several ratios that they use to determine how much money they are willing to lend to different borrowers.
Cost of the Mortgage
When you buy a house, the mortgage is not the only new payment for which you are responsible. You must also pay for homeowner's insurance and any real estate taxes. Banks add this to your anticipated monthly mortgage expenses.
PMI
PMI stands for private mortgage insurance. If you cannot afford at least 20 percent of the home's price as a down payment, you will likely need to purchase PMI to protect the bank's investment.
Front-End Ratio
The front-end ratio is the comparison of the monthly mortgage costs -- including insurance, real estate taxes and PMI -- to your total income. Mortgage costs are usually allowed to make up between 26 percent and 29 percent of your income. For example, if you made $3,000 a month and your bank allowed 28 percent, you could have a maximum monthly payment of $840.
Back-End Ratio
The back-end ratio is the comparison of your total debt payments to your income. This includes credit card debt and college loans, and the total can make up 33 percent to 41 percent of your income. For example, if your bank used 35 percent as the limit, and you have a monthly income of $3,000, your total debt limit per month would be $1,050. If you had to pay $400 a month for student loans, you would thus have a maximum of $650 left for a mortgage payment.
Credit Score
The better your credit score, the more likely banks will be willing to use the upper limits of the ratios for your limits because you have shown a history of repaying credit on time.
Tags: your income, your total, estate taxes, have maximum, income example