Let’s begin by addressing what a debt to income ratio is. It’s pretty much like it sounds. It’s factoring in your monthly payments plus the proposed mortgage payment (PITI = principal, interest, taxes and insurance) and home owners dues, if any. Your monthly gross income that is used for qualifying is divided into the monthly debt which produces your DTI (debt to income ratio).
When someone becomes “preapproved” for a mortgage, it boils down to they qualify for a certain mortgage payment based on their income and debts (DTI aka debt to income ratio). A home buyer qualifies for the loan amount of the new mortgage and their funds available for down payment and closing cost determine the sales price.
This is a common question from first time home buyers. When working with home buyers who are just beginning the process, after discussing credit and other information, I like to ask in return:
- What type of monthly mortgage payment would you be comfortable making?
- How much money are you planning on using for a down payment and closing costs.
To me, it’s better to solve for your potential sales price rather than finding a home or getting your heart set on a certain sales price first before knowing what you actually qualify for.
For example, Seattle Sally has saved up $75,000 and would like to use $40,000 towards a home purchase. She has been paying anywhere from $2,200 – $2,000 a month for rent and would like to keep her payment around $2000.
NOTE: Rates quoted below are from October 2009 and are outdated. If you would like a current mortgage rate quote for your home located in Washington, please contact me.
Beginning with a conventional scenario, a payment of $2038 (principal, interest, estimated property taxes, estimated home owners insurance and private mortgage insurance) with about $40,000 for down payment and closing costs would produce a sales price of $325,000. This is based on a 30 year fixed rate of 4.625%* (apr 4.790).
A sales price of $365,000 with a 10% down payment and the sellers contributing towards closing costs would produce a payment of about $2283.
The only issue I would have with the conventional financing is that private mortgage insurance is that these days, pmi underwriters are picking all mortgages to pieces.
FHA would provide a total payment of $2076 with about $40,000 for down payment and closing costs and a sales price of $325,000. This is based on a rate of 4.875% (apr 5.400).
If we have the seller pay most of the closing costs and prepaids, a payment of $2287 would produce a sales price of $365,000 with Sally bringing in approx. $38,000 for down payment and closing.
One thing to consider, beyond more forgiving underwriting, with FHA is that your mortgage will be assumable. Imagine having a rate of 4.875% a few years from now when rates will most likely be much higher. If you are a seller competing with other similar home on the market, and you can offer an assumable mortgage at a tempting rate–this will be a serious advantage. Once inflation happens, mortgage rates will be much higher.
If Seattle Sally’s credit score comes in lower than expected (this is all based on very preliminary information) FHA may become a better option as well.
*rates quotes are as of 1:30pm on October 8, 2009 and are based on mid credit scores of 740 or higher. Rates can and do change often. Follow me on Twitter to see live rate quotes.
If you’re considering buying a home anytime in the near future, please think twice before purchasing your next car. I’ve had a couple different scenarios lately where the car payment has really impacted the home buyers. Don’t get me wrong, I love cars. Old and new alike. Here’s how it impacts your home purchasing power (based on a 6% mortgage interest rate amortized for 30 years):