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.
Debt-to-Income Ratios
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.
Front-End Ratio
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.
Back-End Ratio
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.
Other Factors
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.
