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

by | BiggerPockets.com

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

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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.

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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.

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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.

About Author

Dave Van Horn

Dave Van Horn is President at PPR The Note Co. - an operating entity that manages several funds that buy/sell/hold residential mortgages, both performing and delinquent. Dave has been in the Real Estate business for over 25 years, starting out as a Realtor and contractor and moving onto everything from fix and flips to Raising Private Money.

14 Comments

  1. Kari Piecuch

    Hey Dave, just a heads up….FHA requires 3.5% down (it was previously 3%).

    Fannie Mae does have a 3% program available called Home Ready, but only applies to owner occupants who do not own any other properties & requires a Homeowner’s education requirement.

    • Kareem Sykes

      Thank you for the information Kari! I checked the HomeReady site a bit, as I am looking to purchase a multi unit (2 or 3 unit property) as a newbie and a first time home buyer if possible. How do I determine if the property I am looking at (in Baltimore City) will qualify for the Home Ready Program/Loan, or is it based on me as the borrower soley? Also, I’ve been hearing quite a bit about a 203K rehab loan as a means to borrow to appreciate the value of the property. Would I be able to utilize the 203K in conjunction with the Home Ready?

      Thanks in advance!

  2. Katie Foster on

    Hi Dave, I second Kari’s comment about about the minimum down payment. For an investment property you’re going to have to put at least 15%down for a CONV loan.

    I also want to add that the ratio requirements that you list in the article are very outdated and are based on underwriting loans manually (before automated systems like DU & LP came out). Most of the time the front radio is now ignored and we’re looking for a back end ratio of 45% or better, although I regularly see them approved as high as 50% for LP and 55% or more for FHA (although if your ratios are that high you’d probably be better if paying off some debt before buying a house).

  3. Eric C.

    Katie’s comment is spot on. Also, you need to realize that some bank/lenders have their own overlays on top of Fannie/Freddie guidelines which are more strict. It’s difficult to come up with what the “magic formula” is without discussing this concept.

    • Dave Van Horn

      Hi Katie & Eric,
      Thanks for sharing! You are both correct.
      There are many guidelines and they are constantly changing. Although this was intended as an introductory article for first-time home buyers, what I didn’t mention in the article is that regardless of what type of buyer you are, you should reach out to your loan officer (or take your banker to lunch) and figure out what they’re looking for, what they’re currently lending on, etc. before finding the deal.
      Best,
      Dave

  4. Krystof Pilisiewicz

    Finally a solid info how banks calculate this! Thank you. And just to confirm, these front-end rexpenses are taken into account before you buy the house and not that you need to have 28% or below after you include your new house.

    I am trying to buy a second house and if I look at my current expenses I get 27%. I assume this should do it.

    • Hi Krystof – the ratios are always calculated factoring in the new loan, however, the front end ratio is only looking at your primary residence expenses divided by your income where the back end looks at all expenses, including your primary residence, all other debt, and the payment on the new house you’re buying. Please do see my earlier post about the ratios we’re (as lenders) looking for today since 28% is very conservative.

      • Krystof Pilisiewicz

        HI, This make sense to me.

        Do you know if banks do this kind of a math when comes to buying a third, or forth house? I just went further and wanted to see if I can qualify for the 3rd house and I`m getting closer to 41% ( I added expenses for 2 house / income x 100) I think If you combining 2 or 3 house it`s very hard to get this 28% but if I go only with my primary residence I can keep hitting this 28%.

        Thank you!

        • Katie Foster on

          Yes, just to be clear, the debt to income ratio calculation is done based on the new transaction you’re trying to qualify for, so it doesn’t matter how many you bought previouly, your front end ratio is always based on the expenses for your primary residence (where you live) and the back end ratio will include your primary housing as well as all other debt payments (including mortgages for other properties) and the payment on the new house you’re trying to buy.

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