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*Step 2: Front-End Debt Ratio vs. Back-End Debt Ratio
Front-end and back-end debt ratios are used by lenders to determine how much you can afford to borrow for a home loan. Each ratio offers a comparison of your current debt amounts to your gross monthly income. Responsible lenders generally don't exceed standard maximum percentage limits unless you make a high down payment or have significant assets. ( Don't know your debt-to-income ratios? See below for more information).
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More on Debt to Income Ratios and Pre-Qualification:
The front-end debt ratio is commonly known as the mortgage-to-income ratio. It is computed by dividing your projected monthly mortgage payment by your monthly gross income. A typical monthly mortgage includes the principal, interest, taxes and insurance amounts.
The standard maximum front-end limit used by conventional lenders is typically around 28 percent. When you apply for a new loan with a standard 20-percent down payment, the lender generally approves you for a request that does not exceed this limit. Assuming the same $4,000 income, your projected monthly mortgage payment maximum is $1,120. The FHA, which offers government-backed loans with 3.5-percent down payments, has slightly less restrictive credit requirements. The FHA typically works with low- to moderate-income buyers.
The back-end ratio is otherwise known as your debt-to-income ratio. This is a broader look at your current debt position and your ability to take on home loan debt. Car loans, personal loans and credit card debt payments are added to your projected mortgage to figure out how much new debt you can afford. If your total monthly debt obligations are $1,400 on $4,000 of gross income, you have a 35-percent ratio. This is just within conventional loan maximums.
The standard maximum limits with the back-end ratio typically are around 36 percent on conventional loans and 41 percent on FHA loans. It covers your payments to the lender if you fail to repay your debt. On a $4,000 income, a 36-percent ratio is $1,440. This means all of your monthly debt payments cannot exceed that amount. If your other loans are $440, your normal maximum home loan payment cannot be more than $1,000.
Speak with a lender of your choice to learn more about how much you can afford based on your specific circumstances. Most lenders are happy to review your debt-to-income ratios informally to give you a ballpark idea of what you might qualify for, this is called 'Pre-Qualification' and most Realtors will expect you to have done this first BEFORE asking to go see homes.