You want the lowest possible interest rate attached to your mortgage loan because this will give you a lower mortgage payment each month. If you take out a $225,000 30-year fixed-rate mortgage loan, you'll pay about $133 less each month with an interest rate of 4 percent instead of 5 percent. Getting this lower interest rate depends on several factors, one of the most important of which is how your gross monthly income relates to your monthly debts.
Mortgage lenders use two debt-to-income ratios -- the front-end and the back-end -- to determine how likely you are to make your mortgage payments each month. The front-end ratio compares your income to all of your debts except for your housing payment. The back-end ratio looks at the relationship between your income and your total monthly debts -- including your housing expenses. The stronger these ratios, the lower your interest rate. That's because borrowers who have higher incomes and lower debts represent lower risks to mortgage lenders.
Most lenders prefer that your total housing payment equal no more than 28 percent of your gross monthly income -- your income before taxes are taken out. Your total housing payment includes the money that goes toward your principal balance, interest, taxes and insurance. Your front-end ratio is determined by dividing your housing payment by your gross monthly income. If, for example, your mortgage payment is $1,800 a month and your gross monthly income is $6,666, your front-end ratio is about 27 percent.
Lenders also want your total monthly debts -- including your estimated new mortgage payment, minimum monthly credit card payments and car loan payments -- to come out to no more than 36 percent of your gross monthly income. If your total debts equal $2,200 and your gross monthly income is $6,666, your back-end ratio will stand at 33 percent.
Your income isn't the only factor that determines your interest rate. Your three-digit credit score also plays a major role. Lenders reserve their lowest interest rates for borrowers whose FICO credit scores are 740 or higher. Lenders also look at your assets, such as a 401(k) plan or a savings account, when determining the interest rate you receive.
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