The Magic Formula Banks Use to Determine Whether You Qualify for a Mortgage

The Magic Formula Banks Use to Determine Whether You Qualify for a Mortgage

3 min read
Dave Van Horn

Dave Van Horn is a veteran real estate investor and CEO of PPR Note Co., a $150MM+ company managing funds that buy, sell, and hold residential mortgages nationwide. Dave’s expertise is derived from over 30 years of residential and commercial real estate experience as a licensed Realtor, real estate investor, and private lender.

Beginning his career in construction and as a Realtor, Dave bought his first investment property in 1989. After years of managing his own construction business, Dave became a full-time real estate investor, specializing in fix and flips, buy and holds, and eventually commercial projects, before moving into note investing in 2007.

Over the past decade, Dave has also invested his time into becoming a connector and educator, who helps others achieve success. He focuses jointly on helping accredited investors build and preserve wealth with his group Strategic Investor Alliance and with general audiences through the annual MidAtlantic Real Estate Investor Summit.

Dave has also shared his strategies and experiences with real estate and note investing via hundreds of articles published on the BiggerPockets Blog and with his acclaimed book Real Estate Note Investing.

Dave has been featured on the BiggerPockets Podcast twice (shows 28 and 273), as well as episodes of familiar podcasts, including Joe Fairless’ Best Ever Show, Invest Like a Boss, Cashflow Ninja, and many others. He also has been a guest of Herb Cohen’s on Executive Leaders Radio, which airs nationwide.

Dave is a licensed Realtor with eXp Realty with CRS and GRI designations.

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Back when I bought my first property, I was working as a real estate agent in an office that owned its own mortgage company and title company. On Saturdays, a guest speaker would come in to teach us about the financing side of the business. I was very fortunate that I was exposed to the information, as it made me a better agent, and by the time I bought my first property, I already felt comfortable with the process.

That said, I know that financing in real estate isn’t always easy to understand. For many first-time home buyers, the process of qualifying for a mortgage can be confusing and intimidating.

So, what is the bank really looking for? How do you know if you’ll qualify and for how much?

Related: Real Estate Financing: How to Choose Between Bankers, Mortgage Bankers & Brokers

Financial Stability

At the end of the day, the bank wants a loan that’s safe. To avoid taking on any unnecessary risk, they’ll review your financial history, and what they’re really looking for is stability.

Typically, they’ll want to see proof of a two-year employment history (pay stubs and W2s) showing that your income is consistent, as well as a two-year record of your occupancy status showing that you’re not constantly moving around.

Some lenders may make exceptions for the two-year employment history if you were in school for part of that time pursuing the career you are now working in.

Of course, there’s also your credit history. Usually, the higher your credit score, the lower the interest rate you’ll qualify for. That said, there is almost always a minimum credit score requirement to qualify.

Down Payment & Mortgage Insurance

The so-called standard down payment amount is 20% of the purchase price. That is not the only option, though.

Down payments with Federal Housing Administration (FHA) loans may be as low as 3%, but they require mortgage insurance premium (MIP).

Some banks may even have competing down-payment requirements on conventional mortgages, where they require private mortgage insurance (PMI).

That said, how much you pay up front (i.e. down payment and points), the lower interest rate you may achieve.

Regardless of whether you go the FHA or conventional route, loan underwriters may also want to see several months of bank statements so that they can verify where your down payment came from. Ideally, it would show that you saved up for the down payment over time.

If your down payment is being gifted to you, the bank may have different requirements, such as a signed letter and proof of the transfer. It really depends on the loan program you’re trying to qualify for.

Either way, the bank often frowns on using borrowed capital for your down payment, and they usually won’t allow it.

Front-End & Back-End Ratios

The formula banks use to determine what you can afford involves two ratios.

Front-End Ratio

The front-end ratio is calculated by adding up any potential housing expenses (i.e. mortgage payments, property taxes, homeowner’s insurance, and even association dues) and dividing it by your gross monthly income (your monthly income before any deductions, such as taxes, social security, or medicare). That number is then multiplied by 100.

Most lenders prefer a front-end ratio of 28% or less. FHA loans may require 31% or less.


Related: When the Bank Cut Me Off, I Had to Get Creative With Financing: Here’s What I Learned

Back-End Ratio

The back-end ratio is similar, except instead of adding up potential housing expenses, it adds up monthly recurring debt and divides that by your gross monthly income before multiplying it by 100.

Monthly recurring debt may include your student loan payment, credit card payment, child support, and any other loan or mortgage payments you have.

Most lenders prefer a back-end ratio that doesn’t exceed 36%.

That said, some lenders make exceptions for higher front-end or back-end ratios if you have good credit or large cash reserves set aside.

Other Assets & Liabilities

Of course, if you have other judgements or liens against you, you may not be approved. The bank wants to know that you honor your financial commitments.

If you’re moving from another property, banks almost always do a verification of mortgage (VOM) to see details on your current/previous mortgage. Or if you’re renting, they can also do a verification of rent (VOR).

If this is not your first purchase, the bank may look at other things as well. For example, how many properties do you own? They’ll want copies of your leases to determine how much rental income you receive.

As a real estate investor, by the time you own multiple properties in your name, the bank may start to cut you off. Sometimes, loan underwriters don’t want to be over-exposed by lending a large amount of loans to one person/business or in the same location.

As the bank qualifies you for a mortgage, they also have to approve of underlying asset (the property). They will likely do an appraisal and multiple inspections to verify the fair market value (FMV) and the condition of the property.


Got It? Now Go Buy a House!

So, now that you know the basics, it’s time to go find your first (or next) deal.

Have any other questions about attaining financing?

Share them below. The BiggerPockets community is a great place for real estate investors of all levels to share their experiences and learn from each other.