Pre-qualification is a relatively easy and straightforward procedure that can let you know whether or not you can afford a house and, if so, how much you can afford to spend. This can be a great first step in the home-buying process, as it can help you establish a price range of homes to look at.
Information You Need to Get Pre-Qualified
Most major lenders allow you to pre-qualify online, since it's such a simple process. Basically, the information the lender uses in determining your pre-qualification amount comes entirely verbally, so the lender doesn't need to collect any documentation and usually doesn't check your credit.
Know your income, assets, and debt information: Since the lender relies on what you tell them to determine your pre-qualification amount, it's important that your information is as accurate as possible. Otherwise, the results aren't going to be worthwhile to you.
Most people have a pretty accurate idea of their income, but there's other information your lender will consider. Before seeking a pre-qualification, you should have an accurate idea of your assets, including the balances in your checking, savings, and brokerage accounts.
And for the debt piece of the puzzle, you should know exactly what your monthly expenses are (other than housing). This includes car payments, student loan payments, and any other recurring obligations, such as the minimum payments on your credit cards.
Calculating How Much You Can Borrow
Basically, lenders use two ratios when determining a pre-qualification amount.
The front-end ratio refers to your expected mortgage payment (including taxes and insurance) as a percentage of your total income, and 28% is a standard amount used by many lenders. The back-end ratio refers to your total monthly debts, including your expected mortgage payment, car loans, credit cards, and student loans.
To get an idea of the maximum monthly mortgage payment (including taxes, insurance, and HOA fees) you could qualify for:
- The front-end ratio: Take your monthly income and multiply it by 0.28. So, if you earn $5,000 per month, you can afford a $1,400 monthly mortgage payment.
- The back-end ratio: Multiply your monthly income by 0.36, then subtract your other monthly obligations. So, if you earn $5,000 per month, you can take on $1,800 in total debt. So, by subtracting your other monthly expenses, you'll find your maximum mortgage payment.
The lender will use the lower of the two results. Bear in mind that some lenders may use slightly different percentages.
Different lenders have different qualification requirements, so it pays to shop around. For example, some lenders will originate a conventional mortgage with 5% down, while many will not. So, if you go for a pre-qualification, and the amount the lender tells you isn't quite what you think it should be, don't hesitate to get a second opinion.
Finally, remember that a mortgage pre-approval is a non-binding document. By issuing you a pre-qualification, the lender is under no obligation to approve you for a mortgage. However, if you are just starting the home-buying process and want to know how much you can afford, a pre-qualification is a good place to start.