So, you are about to take the big leap into home ownership and realize the “American Dream”. This is very exciting and stressful at the same time as this is likely going to be the largest purchase that you have ever made in your life. The first question you will likely ask is, “How much can I afford”. There are a few things to consider when asking that very important question. The answer lies in what the mortgage lender says you can afford and what you personally feel that you can afford.
First, let’s discuss the first question, how much can I borrow? The answer to that question is dependent on your gross monthly income (earnings before taxes) and your monthly debt obligations. Note, the mortgage lender does not consider certain monthly obligations such as electric bills, water/sewer bills, telephone bills, or car insurance when qualifying you for a mortgage. The mortgage lender will look at your monthly payments that are reported on your credit report. There are some exceptions to monthly expenses that the mortgage lender will evaluate when deciding on how much to lend you on a mortgage. For example, you may have a monthly loan payment to a smaller bank that does not report to the credit bureaus. So, if you have an auto loan that is not being reported on your credit bureau, you would still want to inform the lender during the loan process. The mortgage lender will ask you what loans and credit card payments you pay monthly. The lender will then compare your answers against the credit bureau report. Another item that will be counted is child support. Your total monthly debt includes the following: minimum credit card payments, auto and student loans, consumer loans and other financial obligations including child support and alimony.
The mortgage lender is going to calculate the amount that you can borrow based on your debt-to- income ratio (DTI). So, what is debt-to-income ratio? Debt-to-income ratio is your total debt divided by your gross monthly income. For example, if your monthly debt obligations are $2,000 and your monthly gross income is $6,000, then your debt ratio is 33%. Different types of mortgage loans will have different debt ratio guidelines as they vary by mortgage lender, loan program, and investor but generally they range between 40-50%. These ranges include the monthly proposed mortgage payment. To further complicate the matter, some mortgage lenders will calculate and have guidelines for two different debt-to-income ratios. Some mortgages, such as a FHA mortgage, will calculate your new proposed mortgage as a percentage of your income along with your total debt-to-income which includes your current monthly debt plus your new proposed mortgage payment. To qualify for a FHA loan, your proposed mortgage must not be more than 31% of your gross monthly income and be no more than 43% when combined with your other monthly debts. The reason for this type of guideline is because you may have a borrower that currently has no monthly debts. This individual may have an automobile that is paid for and has no loan but the car is 13 years old. This person will likely need to finance an auto in the next 12-18 months. The mortgage lender anticipates that most borrowers will need to borrow additional money in the next 15-30 years. To that end, the lender will want to provide “financial room” for borrowers to acquire other needed loans and still afford to pay the mortgage.
The second question to consider is, how much do you feel that you can afford? You may not feel comfortable with the monthly mortgage payment that the lender says you can afford. You may have very stringent savings goals or prefer to live far below your means to avoid financial stress. To that end, you should look at your current monthly bills, anticipate any other monthly bills that you will incur, and establish a monthly amount that you can comfortably pay. Remember the old saying, it is NO fun to be “house poor”. You will want to still be able to afford entertainment such as movies and going out to eat. You will also want to decorate your new home. So budget wisely to avoid stress down the road.
In summary, ideally you will determine a house budget that both you and the bank says you can afford. Happy house hunting!!!