In a preapproval, a lender examines your financial information, including evidence of your income and your credit report, to determine how much it will be willing to lend. To estimate how much you're likely to qualify for, you'll need to calculate your income and account for every debt you're responsible for, not just those associated with housing. Unlike a prequalification, which relies on the data you provide, preapproval is a strong indicator of the maximum size of your mortgage. Preapproval letters generally are valid for 60 to 90 days.
A preapproval is not a commitment to lend. That can't be determined until you decide on a property and it is appraised. Your preapproval amount also can differ from what you ultimately qualify for if either your debt or income level changes.
Key factors in determining how much you'll be able to borrow include:
- Your debt to income ratio, or DTI
- Your down payment
- Your credit history
- The value of the property
Your debt-to-income ratio is the single biggest factor in determining whether your preapproval request will be approved and for how much, according to a Fair Isaac Corporation study of credit risk managers in the United States and Canada. Two DTI ratios are considered -- the front-end ratio and the back-end ratio.
Front-end DTI Ratio
The front-end ratio measures what percentage of your income will go towards your housing costs. The lender takes your pre-tax gross income from all sources. It then calculates how much your monthly housing expenses are projected to be, including your mortgage principal and interest, property taxes and insurance. The target number here is 28 percent -- lenders like to see your housing expenses at or below 28 percent of gross monthly income, though they may go higher if the rest of the application is strong.
Back-end DTI Ratio
Your back-end ratio takes your gross income and measures it against all recurring debts -- not just your mortgage, but also any car payments, student loans, credit card debt payments and personal loans. The maximum lenders generally accept here is 43 percent, and you're more likely to see lenders balk at someone close to that number than you are to find a lender that will exceed it. You may get more wiggle room here if some of the loans are within a few months of being paid off.
You'll also need to calculate your PITI. This examines your principal, interest, property taxes and insurance as a percentage of your income. The standard here is 29 percent -- you'll have trouble being approved for a loan if yours is higher, particularly if it is over 32 percent.
Down Payment and LTV Ratio
If your ratios aren't quite up to standards, you may be able to win preapproval for a mortgage anyway if you're prepared to make a sizable down payment. The more you put down, the more skin you have in the game and the more you have to lose if you default. This is particularly true if you can afford to pay 20 percent or more of the price of the home. The down payment amount is expressed in the loan-to-value ratio,and the higher the LTV, the bigger the risk you are. If you're prepared to pay $20,000 down on a $100,000 home, your LTV is 80 percent -- a very respectable number. That same amount on a $400,000 home would leave an LTV of 95 percent, and place you in a higher risk pool that would decrease your chance of winning preapproval.
Say you make $5,000 per month and have $750 in monthly expenses not related to housing. Your maximum monthly housing expenses for most lenders would be $1,400 -- or 28 percent according to your front-end DTI ratio. However, your back-end DTI ratio would include your other debts. At the 43 percent figure, that would be $5,000(0.43)-750 -- which in this case gives you the same $1,400 figure. Your PITI at 29 percent would be $1,450 ($5,000 x 0.29).
As a result, you could likely be preapproved for a mortgage that would require an estimated $1,400 per month once taxes and insurance were factored in, assuming your credit score and LTV ratio satisfied the lender.