How much could i be preapproved for

How Lenders Determine Your Pre-Approval Amount

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Most buyers have no idea how lenders determine their pre-approval amount. If you want to know how much you can afford, the conventional advice is: go get pre-approved.

And that’s good advice – only a pre-approval from a lender will tell exactly what your buying power is. But how do lenders calculate that buying power?

Today, we’re going to shed some light on one of the more opaque parts of the home buying process and tell you how they do it. We sat down with Terrence Terrell, a Chicago mortgage lender with Molitor Financial Group.

If your time is short or you hate math, you can also download our buying power calculator. Answer a few quick questions, and it’ll estimate your maximum pre-approval amount for you. Get started here:

Sticking around? Great. In general, your pre-approval amount is based on your debt-to-income ratio, your down payment amount, and your FICO score. Let’s get into it!

How Debt-to-Income Ratio factors into your pre-approval amount

Calculating your debt-to-income ratio

One of the first things that lenders look at when determining your pre-approval amount is your debt-to-income (DTI) ratio. Your debt-to-income ratio is your total monthly debt payments divided by your total monthly income.

Typically, lenders will limit you to a 45% DTI. That means that no more than 45% of your gross income can go toward your debt payments –  including your mortgage payment. 

For example, let’s say your household income is $120,000 per year or $10,000 per month. To calculate your monthly income threshold, you would multiply  45% by $10,000 or $4,500.

Now, you’ll have to calculate your debt. Let’s say you had student loan payments of $400 per month and a $400 per month car note. Your total monthly debt would be $800, and when you take that away from $4,500, you’re left with $3,600. So, $3600 is the maximum monthly payment you might be approved for by a lender.

This monthly payment amount isn’t just your mortgage. It also includes your property taxes and homeowners insurance,  and, if applicable, your private mortgage insurance (PMI), and HOA fees. 

How to calculate your buying power

How does all of this translate into the purchase price? Well, your lender determines the biggest loan that you can be approved for using all of these numbers. But, you can get a rough estimate of that number yourself using a mortgage calculator.  

Our Buying Power Calculator helps you figure out how much home you can buy by inputting a few numbers. Keep in mind, these numbers are an estimate – you’ll want to speak with a local lender to get the best idea of your home purchasing power. 

One important thing to note is that the debt-to-income percentage doesn’t isn’t always 45%. Sometimes the percentage will go up or down depending on the type of loan you’re getting, your downpayment amount, and your credit score. Your DTI ratio can be as low as 43% or as high as 50% for some FHA loans. 

How Down Payment factors into your pre-approval amount

The next thing that lenders look at is your down payment. Your down payment is a percentage of your home’s purchase price that you’ll pay upfront. Most people get conventional loans, which usually require 5% down, but some loans can require as little as 3% down.  

So, for example,  if you plan to purchase a home priced at $400,000, for a conventional loan, you’ll need to have at least 5% of that, or $20,000, for a down payment. 

There are a few incentives to put down a higher down payment, according to Terrence:

• A higher down payment avoids PMI (private mortgage insurance). PMI is usually required if you put down less than 20%.
• Your lender may offer you a lower interest rate if you have a higher down payment.
• If your DTI ratio is too high, a larger down payment will reduce your loan amount and DTI ratio, making it easier for you to get approved for a home. 

Not only will you need funds for your down payment, but you’ll also need money for closing costs (unless you negotiate them into your purchase price). 

Your lender will need proof of deposit to ensure that you have the funds available in your bank account for both your down payment and your closing costs, Terrence says. If you don’t, you’re not likely to get a pre-approval. 

By the way, if you want a full breakdown of all the closing costs that go into buying a place, and get an estimate of how much they will be for you, go here: Closing Cost Calculator. 

How your Credit factors into your pre-approval amount

Your credit is also a factor in the amount your lender will pre-approve you for. 

Most lenders require a minimum score of 620 or more for a conventional loan, Terrence says. FHA loans will allow approved individuals to have a FICO score of 580. Lenders typically reserve the best interest rates for borrowers with credit scores of 760 or higher. 

Having a good credit score will also give you more wiggle room when it comes to your DTI ratio. For example, if you have excellent credit, your DTI ratio can go up to 49.9%.  If your credit is lower, your DTI ratio may go down to 43%. 

Typically, a lower credit score will require a higher down payment. Lenders will often work with borrowers with low or fair credit and suggest ways that they can improve their scores. 

Why It’s Important to Get Pre-Approved

A pre-approval helps you in many ways, the first of which is narrowing down your home search. When you see how much you can spend on a home, you save valuable time by only looking for homes at your price level. 

Secondly, getting a pre-approval helps you be seen as more of a serious buyer to real estate agents. A pre-approval means that you have the backing of a  lender who has already looked at finances and determined what you could buy.

Lastly, as a borrower, you’ll have more bargaining power to make an offer to a seller of a home and have more negotiating power when you’ve already talked to a lender. 

Mike McElroy is the Founder and Managing Broker of Center Coast. He and his team of agents run a real estate practice grounded in proven methodology and accelerated by ground-breaking technology and powerful relationships.

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