So, you’ve decided to take the leap and buy a home. Congratulations! But have you given some thought to what kind of mortgage you can afford? Think about the price of the home as well as the monthly payment you’ll pay to own that home.
Banks take your ability to pay the monthly payment into consideration when deciding whether or not to grant you a loan. If you use the same principle that banks use to narrow your search to homes that you can afford, you will be one step ahead of the game.
So how do you do that? Read on to determine how much mortgage you can afford.
How Much Can You Spend on a Mortgage?
Buying your dream home is a milestone in life that many people reach for. But if you overreach and purchase a home that strains your budget, that dream home may end up being a nightmare. That’s why it’s important to determine how much you can spend on a mortgage before you begin shopping.
Banks use something called a Debt-to-Income Ratio (DTI) as a reflection of your monthly expenses in relation to your income. Not all banks calculate this in the same way, but most do it in one of two ways:
- Front-End DTI Ratio. This formula calculates what percentage your mortgage payment is of your total gross monthly income. To figure your front-end DTI, divide your mortgage payment into your gross (before taxes) monthly income. For instance, if you earn $5000 a month and your mortgage payment is $1,000 a month, your front-end DTI is 20%.
- Back-End DTI Ratio. This formula is a more comprehensive way to determine if you can afford a mortgage payment. To figure your back-end DTI, total all of your monthly payments, including the mortgage, and divide it into your gross monthly income. For example, if you earn $5000 a month and pay $1,000 for your monthly bills, add that to the mortgage ($1,000) and divide it into your income. ($1,000 (bills) + $1,000 (mortgage) = $2,000 / $5,000 = 40%.
Lenders use guidelines that state how much of your monthly income should be spent on mortgage payments – if your DTI exceeds that amount, they won’t grant you the loan. The allowed percentages differ per lender but range from about 36% to 50%. Fannie Mae and Freddie Mac, for instance, issue conventional mortgages and won’t grant loans if a borrower’s back-end DTI exceeds 36%. In other words, if your total bills (including the mortgage payment) amount to more than 36% of your total income, these lenders won’t lend you the money to purchase the home.
In addition to your DTI, lenders also look at other things such as your job stability and your credit score. If your DTI is on the high side and your credit score is on the low side, you may not get the loan. Or you may have recently started a job, and even if your DTI falls within the allowable range, the lender may not see the stability they need to issue the loan.
How Can I Use DTI to Determine How Much I Can Spend on a Mortgage?
Remember, just because a lender tells you they will loan you the money, that doesn’t truly mean you can afford it!
Although some lenders allow a DTI of up to 50%, it’s up to you to determine whether or not you can afford to spend 50% of your income on your mortgage payment. You know your financial situation better than anyone, but it can be easy to get carried away when you’re shopping for your dream home. That’s why it’s smart to use these formulas to stay within your budget:
Formula #1. The 28/36 Rule
Many lenders use the 28/36 rule when determining whether to grant a loan. The rule goes like this: Your DTI should not exceed 28% on the front end and 36% on the back end. That means the mortgage payment should not be higher than 28% of your gross income and your combined debt (including the mortgage) should not be more than 36% of your gross income.
Formula #2. The 25% Post-Tax Model
If you want to be conservative in your numbers, the 25% post-tax model is a great way to determine how much mortgage you can afford. It says that your mortgage payment should not exceed 25% of your after-tax income. For instance, if you earn $5,000 a month after taxes, your mortgage payment should not be more than $1,250. Using a more conservative model will help you deal with financial emergencies in the future because you will have more wiggle room in your finances.
Formula #3. High-DTI
While most lenders strive to ensure that you can truly afford the mortgage payment, some push the boundaries and offer loans to people who have high DTIs. Some lenders approve loans even when the borrower has a 50% DTI. That means someone who earns $5,000 and has $2,500 in monthly expenses can still get a loan.
But if you use this formula to determine how much you can spend on a mortgage, you may be setting yourself up for failure in the future. A high DTI combined with a mortgage can quickly result in failure. For instance, if your expenses were half of your income and your car broke down or you experienced another financial emergency, you may not have the leeway you need to address it.
Now that you have some guidelines, you can determine your DTI and create a plan to look for homes that fit your budget. Using a mortgage calculator online will help you determine your true price range. If you stick to your guidelines, chances are, you’ll still find that dream home in that price range, and you’ll never have to worry about not being able to afford the mortgage! Still have questions on what you can afford? Contact DebtGuru.com to get more expert advice from one of our friendly financial counselors.