Capacity

Capacity

apacity is the real estate industry's way of understanding the financial resources you have available for buying a house.

To determine your borrowing capacity, the lender measures your total income, subtracts your debts and housing expense. They then use these numbers to create ratios (called Front and Back ratios) to rate your finances and decide what mortgages you qualify for.

You may believe you can live on Ramen noodles, walk to work and give up cable TV in order to cover that huge mortgage payment, but the lender wants to be sure you are not overextending yourself and running the risk of foreclosure.

Total income
Any income that is consistent can be used to help you qualify for a loan if it can be verified. If you are a financially-aware consumer, with low consumer debt and stable spending habits, income is probably the most important factor determining your borrowing potential.

Ongoing employment

Ideally, from the banker's perspective, you should have five years of continuous employment in the same field, with at least two years at your current employer. But this is an ideal. Recently employed people can still get a mortgage.

Incremental income
Dependable income is the key to mortgage nirvana, and just about anything counts. Part-time salary, commissions, disability payments, alimony and child support, even seasonal income that can be proven for two years running is beneficial as long as it is likely to continue for the next five years or so.

Stability
If your income history is best described as "erratic," some lenders offer programs, but be prepared to pay more as a premium for the risk of lending you money.

Debts

For home buying purposes, your debts are defined as:

Credit cards
Home equity loans, debt consolidation loans, education and vehicle loans
Insurance payment liabilities
Legal judgments like alimony and child support

Lenders start to get nervous if your non-mortgage debt payments are more that 5% of your monthly income.

It is hard to overemphasize the importance of reducing your consumer debt before applying for a mortgage. Lenders will often reject a loan application from even a high-income borrower if he or she has a lot of consumer debt.

A high down payment may balance out high consumer debt.

If you have the cash in an account or investment that pays less interest than you are being charged for your loans, and this is usually the case, you should withdraw the money and use it to pay off your debts.

But again, you should consider the interest rate consequences. Mortgages generally have interest rates under 10%, and the US government rewards housing debt by allowing you to deduct your property taxes, and home mortgage interest payments (up to $1 million borrowed) from your annual federal income taxes.

This means that your mortgage is usually cheaper than your credit cards, and if you are funding the down payment yourself, you will do better to pay off the consumer debt than to try for a larger down payment.

Housing expense
Housing expense is the third calculation used to determine your capacity because the lender wants to make sure that the mortgage payments fall within a reasonable range for your income and debt level.

A typical 30-year old first time buyer spent around 40% of their income on a house.

Over the years, lenders have seen patterns in buyers' income, debt and spending levels and watched which loans ended up in foreclosure. This led them to develop guidelines for what people can generally afford to spend each month on their monthly mortgage principal and interest payment, taxes, and home owner's insurance premium. Click here for more details.

<< Back Next Step: Down payment stratergies

Information subject to change at any time for any reason Privacy, Licensing and Security, All Rights Reserved