Something that many borrowers get confused about is how the lender comes up with their FHA payment and/or debt ratio. Even if you think you have everything all figured out, chances are the lender is going to come up with different numbers. This could be for a number of reasons that include:
- How you receive your income (full-time, part-time, seasonal, commission, salary, etc.)
- How your debts are looked at (How much longer do you have left to pay them? Are minimum payments reporting or does the lender have to calculate their own minimum payment?)
- What gets included in your mortgage payment (insurance, taxes, etc.)
Because of the variables involved, it is best to talk to a lender about what your effective debt ratio really is and what your mortgage payment would look like if you were to purchase a home with FHA financing.
The FHA Payment
The first thing to consider is how the FHA payment is calculated. There are many factors that go into this payment. Where you live and the type of house you purchase will help to determine many of these factors. Just like every other loan, your FHA loan will have principal and interest charges. This amount is obviously based on the amount of money you borrow, the length of time you borrow it, and the interest rate you are charged. It will also depend on the type of term you choose, whether a fixed rate term or an adjustable rate term. The next variables change based on many factors:
- Real estate taxes – These obviously differ for each house and each area. The amount of your real estate taxes for the entire year will be divided up into 12 payments to figure out your debt ratio effectively.
- Homeowner’s insurance – This amount will also differ based on the insurance company you choose as well as the type of coverage you choose. Your annual premium is also divided up amongst 12 payments throughout the year and added to your mortgage payment.
- Flood insurance – If you live in a designated flood area, you will be required to obtain flood insurance, which is in addition to your homeowner’s insurance. This premium will be divided up amongst the 12 months to add to your payment as well.
- Association fees – If you live in a condo or even a single family home where an association governs the area, the fees will be added to your monthly mortgage payment to figure out your debt ratio.
- Mortgage insurance – Every FHA loan has mortgage insurance that is paid on a monthly basis. The annual premium is based on your original loan amount and is then divided up into 12 payments and added to your mortgage payment. Right now that amount is 0.85 percent of the loan amount.
Each of these figures is added to your principal and interest payment to come up with an effective FHA payment, which is just a part of your debt ratio. This part is called the front-end ratio, which for an FHA loan should be no higher than 31 percent.
The Other Debts
Your back-end debt ratio is based on your other monthly debts. This includes things like:
- Car payments
- Student loans
- Credit card payments
- Installment loans
- Personal loans
These payments are added up with your FHA payment and then divided by your gross monthly income to come up with an effective back-end debt ratio. For an FHA loan, this calculation should not be higher than 43 percent. There are certain payments that may be excluded from this amount including any payments that have less than 10 payments left, unless they are open-ended credit accounts, such as a credit card. Any student debt that is currently deferred will need to be included, however, so do not forget to include that in your calculations.
Your income is probably the most confusing factor when it comes to qualifying for an FHA loan. What you think you make, might not be the amount the lender uses for qualification purposes. There are many reasons for this including that your income is not consistent. For example, if your income is seasonal, part-time or volatile. It happens when you are self-employed and get only commission income. The FHA lender will figure out your effective income by getting an annual average of the income. For example, if you work on a commission-based income, the lender will annualize the income which might make the amount you make look lower than it is, but it takes into account the slower times of year that would make it harder to afford a higher mortgage payment. Talking to a lender about how your income would be calculated is the best way to determine your effective qualifying income.
Putting it all Together
Once you know your effective FHA payment, qualifying income, and included debts, you can see how the FHA lender comes up with your debt ratio and loan amount. Even if the amount seems lower than you would have anticipated based on any loan calculators you used online, it is in your own best interest. FHA lenders do not want to give out loans to borrowers with debt ratios much higher than the 31/43 limits that are set forth by the FHA in an effort to decrease the number of foreclosures they must take on. Of course, FHA loans are backed by the FHA and the lender will get their money back, but it does not look good for the lender if they have to call upon the FHA for a guarantee payment.
If you are unsure about how your financial picture will look to a lender, gather your necessary documents that include your pay stubs, W-2s, bank statements for the last 12 months, last two years’ tax returns, and your credit report and talk to a lender. They will help you figure out your effective income and debt ratio, guiding you to the right loan amount for your FHA loan and affordable FHA payment.