Mortgage Qualifying Benchmarks
If you've used a mortgage qualifier calculator on another website, you have probably seen the two standard benchmarks used to determine how much of a mortgage you qualify for. They are the PITI to income ratio and the debt to income ratio. In case you're not familiar with how these ratios are arrived at, or how they impact your home loan qualification, let's discuss each of them separately.
PITI to Income Ratio
The PITI to income ratio is one of two common formulas used to determine how much a lender is willing to borrow to a home buyer. PITI stands for Principal, Interest, Tax, and Insurance, which are the four parts that make up the typical mortgage payment. A fifth part, Private Mortgage Insurance (PMI) may also be included in the PITI figure where it applies (down payment is less than 20% of the home price).
The PITI to income ratio is calculated by dividing the total mortgage payment (PITI and PMI) by your gross monthly income. Since most home lenders only allow a maximum PITI to income ratio of 28% (though some lenders may go as high as 40%), you can determine your maximum PITI mortgage payment by multiplying your gross monthly household income by 28%. So if your gross monthly household income is $4,000, the most your monthly PITI mortgage payment can be is $1,120 (4,000 X .28).
Debt to Income Ratio
The debt to income ratio is basically the same as PITI to Income ratio, except that it also includes all non-mortgage monthly debt payments. So to calculate your debt to income ratio, you would add up all of your monthly non-mortgage payments (car payments, credit card payments, loan payments, etc.) and then add that result to your PITI mortgage payment. You then divide your total monthly mortgage and debt payments by your gross monthly household income to arrive at your maximum combined debt and mortgage payment.
Since most prudent home lenders allow a maximum debt to income ratio of 36% (though some money-hungry lenders may go as high as 48%), you can determine your maximum combined debt and mortgage payment by multiplying your gross monthly household income by 36%. So if your gross monthly household income is $4,000, the most your monthly combined debt and mortgage payment can be is $1,440 (4,000 X .36).
The Lesser of Two "Ratios"
Once the home lender has determined your maximum mortgage payment and your maximum combined debt and mortgage payment, they then use an algorithm to determine the maximum home loan amount for each. The lesser of these two loan amounts is then used to determine the maximum home loan you will qualify for. The mortgage prequalification calculator on this site attempts to mirror that qualifying process in its calculations.
A Third Ratio to Consider
A third ratio you should consider while determining the size of a home loan you want to qualify for is what I call the Financial Freedom Ratio, which is the amount of free time you have relative to the number of hours you are awake.
While there is no formula for calculating your financial freedom ratio, it's important to recognize that the more you spend to own and operate a home, the less discretionary time you will have at your disposal. I know a lot of families who are so busy working to pay for their expensive homes that they have little time to actually enjoy the homes they purchased. Sure, they have a nice house, but they have NO LIFE!
So please remember this when applying for a mortgage: Lending institutions could care less whether or not you have a life outside of working to pay for your home, i.e., your financial freedom ratio. All they care about is whether or not you make your house payments as they come due.