Summary: This article explains the mortgage qualification process by describing the calculations that lenders typically make in determining how large a mortgage loan you can afford. First, it describes the requirement for a minimum down payment. Next, it explains the ratios used to factor in your income and monthly debts.
We start by assuming a minimum down payment of 3 percent, and that your savings funds will have to cover closing costs as well as the down payment. You can override the default requirement of a 3 percent down payment when you recalculate. As recently as early 1998, a minimum requirement of 5 percent was more common.
If the calculator shows that you are constrained by the down payment, there are a number of options. FHA, VA and some private lenders allow a lower down payment (although few private lenders allow down payments of under 3 percent). Also, you will find that by saving up for a while you can really increase the size of the home you can purchase.
It is a good idea to put down 20 percent if you find it possible to do so for the house that you wish to buy. However, 20 percent is a "nice-to-have" as opposed to a "must have." I have seen estimates that over 1/4 of all mortgages go to borrowers with lower down payments.
People with high incomes and very little savings tend to get very upset with the down payment arithmetic used in calculators. However, the fact is that if you have $5,000 in savings and the down payment requirement is 5 percent, then basic arithmetic says that the house price cannot exceed $100,000. It will be less, because some of your savings has to go toward closing costs.
There is no need to take offense at the arithmetic. If you think that you can afford more, change the closing cost percentage, lower the down payment requirement, or increase what you enter for your savings. All of these options are easy to change when you use a calculator.
Income and Debt Ratio
Mortgage qualification, or mortgage underwriting, is a pseudo-science. The mortgage lender is trying to determine whether or not you can and will meet the payments on the mortgage. Because no one can predict exactly who will meet the payments and who will default, mistakes will be made. Some "good" borrowers will be turned down, and some "bad" borrowers will receive loans.
What this means to you as a borrower is that your application for mortgage credit will be evaluated according to some rules of thumb that appear to be precise, such as "the ratio of your monthly payment to your income should not exceed 28 percent," or "the ratio of your monthly payment plus monthly non-housing debt to your income should not exceed 36 percent." However, everyone knows that these rules of thumb are not completely accurate.
Because the rules of thumb are simplistic, lenders are not rigid in using them. On the one hand, you can "pass the test" of having enough income to satisfy the 28/36 percent ratios and still get turned down for a mortgage loan. On the other hand, you may "fail" to meet the test and still have your application accepted. These exceptions are discussed below.