In this series, we are reviewing the five pillars that determine a borrower’s eligibility and buying power: Capacity, Capital, Credit, Collateral, and Character. In this article, we will focus on Capacity. What it is, why it matters, how it’s calculated, and the factors that can affect it.
Capacity plays the most significant role in determining how much a borrower can qualify for. If credit were a car, capacity would be the driver. It is also one of the most misunderstood and complex pillars, which often leads to the most questions.
Capacity determines how much a borrower can afford on a monthly basis. It is calculated using a ratio called the Debt-to-Income (DTI) ratio. A general guideline is that no more than 50% of a borrower’s gross monthly income (before taxes) should be used to service all personal debt.
To calculate this ratio, we first need to determine income. This is where things can get complex.
What type of income do you have? Are you W-2, 1099, self-employed, receiving Social Security, disability, retirement/pension, child support, or alimony? Are you full-time, part-time, seasonal, hourly, salaried, or commissioned? Do you receive bonuses, overtime, tips, or commissions on top of your base income? How long have you been employed or in business? Is your income increasing or decreasing year over year? Do you have rental income? Is your income likely to continue for at least three years?
A general rule is that variable or self-employment income typically requires a two-year documented history. This includes most income beyond base hourly (40 hours/week) or salaried income, unless it is guaranteed for life such as Social Security, permanent disability, or pensions.
Hourly Rate × Hours per Week × 52 Weeks ÷ 12 Months = Monthly Income
Annual Salary ÷ 12 Months = Monthly Income
(2-Year Total Overtime) ÷ 24 Months × Current Overtime Rate = Monthly Income
(2-Year Total Bonus/Commission) ÷ 24 Months = Monthly Income
Self-Employed Income = 2-Year Combined Taxable Income ÷ 24 Months
Base Pay:
$32/hour × 40 hours × 52 weeks ÷ 12 months = $5,546.67
Overtime:
$48/hour × 6 hours × 52 weeks ÷ 12 months = $1,248.00
Total Monthly Income:
$5,546.67 + $1,248.00 = $6,794.67
As mentioned earlier, we can generally use up to 50% of gross income to service debt:
$6,794.67 × 0.50 = $3,397.34
This is the maximum monthly amount available for all debts.
Next, we subtract existing obligations. Debt includes any contractual obligation with a balance and payment, such as:
This does not include non-contractual expenses like subscriptions, gym memberships, auto insurance, and cell phone bills.
Credit Cards: $234.65
Auto Loan: $742.87
Student Loans: $218.59
Personal Loans: $195.43
Total Monthly Debt:
$1,391.54
$3,397.34 − $1,391.54 = $2,005.80
This leaves a monthly housing allowance of $2,005.80.
Your monthly housing payment includes:
Purchase price qualification can vary significantly based on property type and location.
Property A:
Single-family home at $325,000
No HOA Insurance: $195/month Property taxes: $1,400/year
Property B:
Condo at $325,000
HOA: $200/month Insurance: $252/month
Property taxes: $2,100/year
Even at the same purchase price, these properties carry different monthly obligations. A borrower may qualify for one but not the other due to these differences.
Another major factor is the interest rate. Two identical purchase prices can result in very different monthly payments depending on the rate, loan program, and down payment.
While 50% is a solid general guideline, actual DTI limits vary based on:
For example:
Everything outlined here provides a strong foundation for understanding how capacity is calculated. It highlights why it’s so important to speak with a mortgage advisor early in the process, before applying, before pulling credit, and before house hunting.
Every consultation should start with a conversation. That conversation determines the next steps: improving credit, increasing savings, stabilizing income, or moving forward with purchasing a home.
Let’s start that conversation today.
Taylor Kite | NMLS 2127979