Before you buy a home, you need to know how much you can afford to spend on a home loan. Otherwise, you could face financial difficulties and significant debt. Below, the Mortgage Mark team explains the meaning of “purchasing power” and how to calculate yours.
What Is Purchasing Power?Your purchasing power, or buying power, is how much you can afford to spend on goods and services. In a home loan context, it determines how much you can spend on monthly mortgage payments. In other words, your purchasing power determines your credit limit.
How Is Purchasing Power Calculated?Your debt-to-income (DTI) ratio determines your purchasing power. Your DTI ratio is the comparison between:
- Your monthly income; and
- How much you spend on outgoings e.g. bills.
What Is Purchasing Power Parity?There’s one other term we should clear up, and that’s “purchasing power parity” (PPP). This is, essentially, a type of exchange rate. It erases the differences in currency values between countries to equalize purchasing power across the globe. What about in a property context? PPP reveals how much a home is actually worth rather than how much it’s worth in a given currency.
Purchasing Power Parity – How to Calculate PPPHow do you calculate purchasing power parity? In simple terms, though, you can:
- Take the cost of a property in a given currency; and
- Multiply it by the price for the same property in another currency.
DTI Requirements for Various Loan Programs
Different loan programs have different DTI requirements. They also have different underwriting guidelines and acceptance criteria. Knowing the requirements helps you decide which loan to apply for.
Conforming loans typically have a 45% threshold for DTI. Occasionally the automated underwriting systems will allow for a DTI ratio to be as much as 50% or 55%.
Jumbo Loans are typically the most conservative. They have strict DTI requirements.
Jumbo loans limit the debt-to-income ratio to 43%. The loan will become a non-qualified mortgage (non-QM) when the DTI surpasses 43% on a jumbo loan.
Non-primary homes often have more restrictive DTI ratios. So, for example, vacation homes have stricter DTI ratios (and often greater down payment requirements). What does this mean? In practical terms, you may have less purchasing power over second homes and vacation properties.
Higher DTI Requirements with Higher Credit Scores
Credit scores will impact how much home someone can afford because they impact the interest rate and mortgage insurance. Both the rate and MI impact the monthly mortgage payment, which is used to calculate the debt-to-income ratio and purchasing power.
Most loan programs require approval from an automated underwriting system that evaluates the overall profile of a loan. These underwriting systems consider the credit, income, and assets when issuing loan approvals.
Higher credit scores translate to lower credit risk for lenders. Meaning, systems are more likely to approve buyers with better credit scores and higher DTI ratios.
Debt-to-Income Calculator Explained
Let’s now break down our debt-to-income ratio calculator to calculate purchasing power.
A mortgage payment calculator helps to estimate the home loan’s monthly payment. A debt-to-income calculator calculates the DTI ratio and determines the purchasing power.
The default settings in the DTI calculator are for primary homes in the DFW area. Various fields can be modified and are notated in blue.
1. Input Loan Terms
The first data points to enter in the DTI calculator are the sales price, down payment percentage, interest rate, and loan duration. A start date is needed, but the actual date is not important.
Check out our page on mortgage down payments to learn about the minimum down payments required for each loan program.
2. Interest Rate Input
Mortgage interest rates change daily. They’re determined by a number of parameters. The only way to truly know what an interest rate will be is to get pre-approved. In the interim, an interest rate can be found at FreddieMac.com.
Freddie Mac’s rates are only updated on Thursdays, but they are determined by actual loans in process. Freddie Mac’s website only shows interest rates associated with mortgage points.
For a no point loan the interest rate may be .25% to .5% than what is shown (assuming that a no point option is available). Freddie Mac only offers financing for conventional loans with conforming loan limits. Regardless, the Freddie Mac interest rate can be used as a placeholder for the government loans (like FHA, VA, and USDA) since those rates aren’t published.
Enter Program, Occupancy, and HOA
The next input in the DTI calculator is the occupancy, program, and monthly HOA dues.
For occupancy, “Homestead” means you plan on living in the home as your primary residence.
The default loan program is set to conventional financing.
Enter the mandatory HOA dues. While this amount is not included in the monthly payments, the HOA does need to be included for the DTI calculator.
Erroneous Inputs Show Red
Enter Property Taxes & Homeowner’s Insurance
Property taxes and homeowners insurance are considered mortgage prepaids. The default rates are generic for the north Texas area. Edit these numbers as needed.
The debt-to-income calculator requires that these fields have a value; regardless if escrow are waived. Waiving escrows is only an option for conventional loans when the loan to value is 80% or lower. Conversely, all other loan programs (like FHA, VA, and USDA) require that taxes and insurance be paid as part of the mortgage payment.
The monthly MI factor will update automatically. For conventional loans, the MI rate is estimated using a 720 credit score. For other programs (like FHA and USDA), the MI factor is set based on the program’s guidelines.
Liabilities for DTI Calculations
The debt-to-income ratio is calculated by dividing the monthly debt obligations (including the potential new mortgage payment) by the gross monthly income.
If it’s a court-ordered debt then you have to count it. Examples for this include child support, alimony, IRS tax lien payments, etc. These items will not appear on a credit report so please disclose this to us up front.
Credit Card Minimums
The mortgage industry will use the debts on a credit report and count the minimal monthly obligation. For credit cards, the monthly statement shows the minimum amount payable.
For example, if Joe has a $5,000 balance on a credit card and the monthly obligation is $100 per month, the mortgage industry will use the $100 even if Joe pays $500 to get it paid off quickly.
Student Loan Debt
Student loans that are in deferment still need a monthly payment for DTI calculations. The monthly payment amount is either determined by the student loan creditor or the mortgage loan program.
Ideally the student loan creditor can provide documentation for the future payment. If this is not available, the mortgage industry will require that a monthly payment be calculated based on the loan’s balance.
For government loans (like FHA, VA, and USDA), the monthly payment for the deferred student loan is calculated by taking 1% of the loan balance. For example: the mortgage industry will use a debt obligation of $300 monthly for a $30,000 student loan debt that is deferred.
For conventional loans, you calculate the monthly payment of the deferred student loan by taking .5% of the loan balance. A $30,000 deferred student loan uses a $150 per month obligation for the DTI calculator.
Debts to Exclude
Monthly debt obligations on a credit report need to be counted when calculating the debt to income. Conversely, normal living expenses do not need to be included in the DTI calculator.
The following living expenses should not be counted toward the loan’s DTI calculations:
- Utility bills e.g. water bills
- Cell phone billsCable bills
- Church tithes
- Insurance payments e.g. auto insurance
These debts don’t show up on credit reports so there’s no need to include them for DTI calculations.
Other Debt Exclusions
Debts can be excluded if there is legal documentation that removes the financial obligation. For example, if a divorce decree awarded the borrower’s ex-spouse with the previous home (and mortgage), that debt obligation does not need to be counted in the DTI calculation.
There is a possibility that debts may be excluded if they are installment loans with only a few payments remaining. For example, a car loan with five months of payment left could be omitted. Typically debts with less than 10 months remaining may be excluded.
Income for DTI Calculation
For the “normal” salaried, W2 employee the income is simple: use the before-tax monthly income. The same goes for fixed income sources (like pensions, VA benefits, social security income, etc.).
The variable sources of income require greater scrutiny. Check out the qualifying income page to determine how to calculate other types of income for the DTI calculator.
The DTI calculator is not perfect. It should be used alongside other tools to determine a loan’s suitability.
Loan Officer, NMLS # 729612