What Key Factor Determines Purchase Power?
by Michael Lam | Jul 05, 2015
Determining your exact purchasing power isn’t a straightforward formula. Every lender has different guidelines, but there are some common characteristics lenders use. They all use some form of threshold that they rely on to filter out unqualified borrowers. This threshold can be referred to as the “Debt to Income” ratio, also known as the DTI factor. It’s essentially a risk tolerance that tells a lender how much debt you can carry based on your income.
The DTI is a percentage of your income devoted to paying off your existing debt. Debt is anything that you owe and are required to pay back. Debt is recorded in your credit file. Keep in mind there are different types of debt. For most lenders, they care about recurring debt that is consistent in amounts. This type of debt generally consists of, but is not limited to:
- Existing mortgage debt (existing home or rental properties owned)
- All credit card debts (amounts due and have not been paid off)
- Utility bills on existing home and all existing rentals that you may own
- Home insurance on existing home and all existing rentals that you may own
- Automobile Insurance
- Automobile financing or lease payments
Michael Quihuiz, a loan officer who is well respected in his circle and has more than +7 years of experience, states that typical banks will use a threshold of 45% DTI for loans less than $417,000. Some lenders will go as high as 43% DTI for larger loans beyond $417,000 loan amount.
Anyone can calculate their DTI. It won’t be “official” but you can come very close to what a lender will calculate. You should look at your past months bills. Add up all bills that you pay and that becomes your “debt.” An exception to understand is if you have credit card bills but you always pay them in full, you don’t have to account for them. In other words, lenders are looking for outstanding debt. So even if you have a credit bill of $2,000 last month but you paid it in full. You’re not carrying any “recurring” debt. However, auto financed payments for example is recurring debt.
To calculate income, you must add all of your income that you make (before taxes) for the same month. Income means consistent income you can document. I will not go over non-W2 income. That will be discussed in another article. For simplicity sake, we will use a typical W2 employee type income that is fully documented by your employer. I would not include any other income that is not consistent on a month to month basis. You could include interest income if you’d like but you should be prepared to give documentation for this interest income and its consistency going back as far as 2 years to qualify as income. This is dependent on lender guidelines (check with your lender).
Once you have debt added for the month and income added for the month, you take the debt and divide it by the income. That will give you a decimal value which you will multiply by 100 to give you the DTI percentage value.
Now that you have the DTI (before accounting for any new mortgage), you must figure out, how much additional monthly debt could you take on within the lenders threshold DTI. This “additional” amount is the loan monthly amount you could carry in addition to your existing debt. This additional amount could be called the Additional Debt to Income (ADTI)
Lender_Threshold is the 45% that most lenders will use. For this article we will stick with using 45% as the DTI threshold.
Let’s say Cinderella is a potential borrower. Before she goes out soliciting for reviews of her potential purchasing power, she wants to do some homework. She understands the threshold most lenders will use is 45%. She calculates her debt for prior month and also goes back a full year to see the consistency. She comes to a total monthly debt of $1,500. Her monthly income she gets from her employer is $5,000 before she is taxed. This means she is making annually $60,000. Her DTI is:
- DTI = Monthly_Debt / Monthly_Income * 100 = 30%
- DTI = $1,500 / $5,000 * 100 = 30%
30% is lower than 45% (DTI threshold). This means her debt is low enough to support additional debt to carry a new mortgage. How much more can she afford? You must calculate the Additional Debt to Income amount (ADTI).
- ADTI = (Lender_Threshold – DTI) * Income
- ADTI = 0.45 – 0.30 = 0.15 * $5,000 = $750
Cinderella can support an additional monthly debt of $750. So this means new mortgage that she is looking to obtain should not be higher than $750 monthly.
Once you know your ADTI, you can use it to shop around, understanding and expecting your next mortgage will be no higher than this amount. If a lender is willing to increase your debt, you should be concerned and ask questions. If most bank uses 45% and a bank you’re working with uses a higher amount that should tell you one of two things; the bank either really trusts you or the bank is being way to aggressive and risky. Always seek clarification and know your own risk tolerance. The DTI is a great risk tolerance for you to hold yourself. Lenders have done studies to figure out what the threshold is before a borrower is likely to have difficulty making monthly payments.
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