Mortgage calculations are mathematical equations used to help us (and your lender) learn whether we qualify for a mortgage, or if we need to make adjustments in our finances to improve our debt ratios. Mortgage calculations are actually at the heart of the entire mortgage approval process. If the calculations are too high, the loan requests will not be approved. Knowing the math limitations of mortgage guidelines is helpful to make sure our calculations work well before we apply for a mortgage.
Mortgage calculations are important tools to lenders who "crunch your numbers" to be sure you can afford the loan that you are applying for. Your debt ratios come into play when a lender must look at your use of credit and the monthly payments created, then compares this total to your income. Total monthly payments divided by gross monthly income = debt ratio. Example: The Federal Housing Authority FHA states that all of your monthly consumer debts (credit card, car, student loan payments and the new house payment PITI+MIP (principal, interest, taxes, insurance and mortgage insurance premium) divided by your gross income should not exceed 43 percent of your gross monthly income. The new home payment (PITI+MIP) should not exceed 31 percent of your gross monthly income.
FHA was the first to offer a method of calculation of borrowers' debt ratios to ensure affordability and fewer defaults. In 1934, President Franklin Roosevelt and Congress created FHA to provide low-interest loans to borrowers with low down payments. Millions of people were out of work and the economy was flattened. Banks that offered mortgage loans required 50 percent down payment (resulting in a 50 percent loan to value calculation), so only a very few people could afford to purchase homes. Additionally, FHA insured its loans so that the lender had a way to recoup losses in the event a borrower defaulted. (FHA still works in this way today.)
Example of mortgage calculations: In 2010, FHA down payments are calculated at 3.5 percent of the purchase price of a home ($100,000 X 3.5%=$3,500=base loan amount is $96,500). Due to all of the foreclosure activity, Mortgage Insurance Premium is now calculated at 2.25 percent of the loan amount. ($96,500 X 2.25%=$2,171.25+ $96,500=$98,671.25 total loan amount).
Borrowers benefit from mortgage calculations because they can learn how their level of debt effects their ability to qualify for a home loan. By paying down debt and decreasing monthly payments, debt ratios decrease and credit scores increase. Lenders benefit from mortgage calculations. When combined with credit scores and credit history, calculations easily show a mathematical picture of the borrower's ability to be financially responsible.
There are several ratios used in mortgage calculations. Lenders figure "loan to value" (LTV) ratios by comparing the loan amount to the value of property (loan amount divided by property value=LTV percentage). Fannie Mae and Freddie Mac (conventional lending) limit purchase LTV percentage to 90 percent of the purchase price (meaning a 10 percent down payment). Conventional lending requires all consumer monthly payments plus a new monthly mortgage payment not to exceed 36 to 38 percent of gross monthly income. This is called a debt to income (DTI) ratio. Calculate your DTI ratio by dividing the total of all monthly payments by your gross monthly income.
The VA (Veterans Administration) only has one DTI limitation; the veteran's new home payment plus all of his monthly consumer payments can be as high at 43 percent of his monthly income. In the event he has no other consumer debt, the entire housing payment of principal, interest, taxes and insurance can take up to 43 percent of his monthly income.
Mortgage calculations are affected by your credit scores. Fair Isaac Corporation created credit scoring, which is used throughout the mortgage industry. Monthly payment history and how much you owe play a big part in mathematical algorithms which calculate credit scores. Scores are used as predictors of likelihood of whether a borrower will default on a loan. If your credit scores are low (less than 640), you will be limited on the type of loan you can qualify for. The lender may set some restrictions if approving a loan with lower scores. Lenders may look for very low debt ratios or funds in savings for reserves as a way to offset a lesser credit score.