This the question everyone wants to know.
You’re finally ready to stop renting and buy, but how do you know how much
home/mortgage you can afford. Well, there are several key factors mortgage lenders consider: Debt-to-Income Ratio, Credit Score, Interest Rate, and down payment / savings.
We’ll take a look at each of these variables separately.
Calculating Your Debt-to-Income Ratio
Without a mortgage loan, most individuals can’t afford the home they want. When you apply for a mortgage, the lender will examine your financial data and perform a series of calculations to determine how much you can borrow. One of those calculations is your debt to income ratio.
Both income and debt play important parts in getting a mortgage. In general, the higher your monthly income, the more you can afford to pay each month toward your mortgage. Any debts that you have count against your income in determining how much you can borrow. Mortgage lenders calculate metrics called front-end and back-end debt-to-income ratios by plugging your annual salary into a mathematical formula.
The front-end ratio is your new mortgage payment (principal, interest, property taxes, and insurance, plus other items like homeowner dues if applicable) divided by your gross monthly income. So if your monthly income is $10,000 and your total house payment is $2,500, your top or front-end ratio is 25%.
Add your other expenses – a couple of car payments at $400 each and a $200 in credit card payments – to your housing for a total of $3,500 a month, and you have a back or bottom-end ratio of 35%. This falls within most lenders’ guidelines, assuming that you have decent credit and a little money in the bank.
Typically, mortgage bankers don’t want your front-end ratio to be more than 28% and they want your back-end ratio to be 36% or lower.
Money in the Bank!
Lenders want to make sure that mortgage borrowers can make their monthly payments for the next 15, 20 or 30 years. Besides checking your income, lenders will also examine your savings to determine how much they can loan you. More money in savings means you’ll have reserves to draw on if your income falls or fails to grow in the future. More savings also means you can make a larger down payment, reducing the amount that you need to borrow and increasing the amount of equity you have in your home from the beginning.
FHA loans can require as little as 3% down, while conventional loans are looking for you to have 20% down.