How do mortgage lenders decide how much to lend?

Lenders use a variety of factors when determining how much to lend. Loan limits and debt ratios are the two most important factors. Credit scores and down payments also come into the picture, to some extent. So let’s talk about each of these factors in turn.

Loan Limits Vary by County

Both FHA and conventional mortgages have loan limits associated with them. As you might have guessed, they limit the size of the loans that are available to borrowers. So this is often a starting point for the maximum amount you can borrow.

For instance, a “conforming” home loan is one that conforms to the size limits established by Freddie Mac and Fannie Mae. Currently (in 2014) Freddie and Fannie will purchase mortgages up to $417,000 in most markets, or up to $625,500 in pricier markets like San Francisco and New York City. Anything above this is considered a “jumbo loan” and will likely require a larger down payment and higher credit scores.

FHA loans also have limits, and they are lower today than in the past. In 2014, the Department of Housing and Urban Development (HUD) announced it was lowering the “high cost” ceiling to $625,500, for a single-family home. If you don’t live in a high-cost area, the limits are even lower. According to HUD: “While there are many changes in loan limits for so-called high-cost areas, the national standard (floor) limit remains at $271,050 for 2014.” Again, these numbers apply to FHA loans in particular.

But these are just general caps on the maximum size for each county across the U.S. I think what you’re really asking is: How do mortgage lenders decide how much to lend to a particular borrower? They do this, primarily, by measuring the person’s debt-to-income ratio. So let’s talk about that next.

Lenders Use Debt Ratios to Decide How Much to Lend

On an individual borrower basis, mortgage lenders use the debt-to-income ratio (DTI) to decide how much to lend. They look at the amount of money you earn each month, in relation to your recurring debts.

The math is fairly simple. To calculate your DTI ratio, you would simply add up all of your monthly debt payments and divide them by your gross monthly income. Based on this calculation, the lender will determine how much they are willing to lend you.

These days, most lenders are capping the total DTI (including mortgage payments) somewhere between 36% - 43%. This means that if your combined debts exceed this range, you could have trouble getting approved for a loan. In fact, it’s one of the most common reasons for being denied.

But these numbers are not set in stone. Some banks and mortgage companies will allow slightly higher ratios if they feel the borrower is well qualified in other areas. The only way to find out where you stand it to speak to a lender and/or apply for a loan.

Credit Scores and Down Payments Play a Role as Well

Credit scores can be a factor as well. Your credit score is a three-digit number that shows how you have borrowed and repaid money in the past. Basically, a higher score shows that you are less risky as a borrower. In contrast, a lower score indicates a higher risk to the lender. Borrowers with excellent credit tend to have an easier time qualifying for mortgage loans, even if their debt-to-income ratios are a bit high.

Down payments also play a role here. A larger down payment could help you qualify for a larger loan, with all other things being equal.

Generally speaking, mortgage companies are willing to lend more to well-qualified borrowers who make down payments of 10% - 20%. On the other hand, they tend to lend less to borrowers with credit blemishes and smaller down payments.

Read: How much can I borrow with my income?

Recap: So let’s revisit the question at hand: How do mortgage lenders decide how much money to lend? They typically compare your current debt level to your gross monthly income, and then factor in the estimated monthly payments for the new loan. While there are other factors involved, debt ratios tend to weigh the most. There are compensating factors to consider as well. For instance, higher debt ratios might be allowed for borrowers with good credit scores and larger down payments. But none of this is set in stone. Lending standards vary from one lender to the next.