Figuring out how much mortgage you can afford is a process that involves several steps. However, once you have gone through all of them and have thoroughly examined your financial situation, you can have a much better idea as to how big of a loan you can afford, and in turn, how big of a house to look for.
Lenders are using strict debt to income ratios in these tight lending markets. So, it is imperative that you get a basic understanding on how this is done. Typically lenders are looking for debt to income ratios of 34-38% in order to qualifyfor a mortgage. Higher percentages are allowed with compensating factors on certain mortgage products.
I have always liked to keep things simple and short with my how to articles. There is no need to talk financial mumbo jumbo when we can make this simple for everyone to understand. This is basic math.
- The first step is to calculate your gross monthly income.To do this, simply figure out how much money you are making each month from all of your documentable sources throughout the year and now divide that by 12. Remember I said “documentable”. If you can’t prove it, it didn’t go in your bank account and or you do not claim it on your taxes, then it is not provable income. If you are a couple, figure both incomes into the equation.
- Next, add up all your debts that you are liable for. Things like a car, credit cards and stuff that will show on your credit report is what we are looking for. Figure out what percentage of your income is going towards paying debts. Generally, figures like 5%, 10%, or 20% are used. Of course, the lower the better, as you will be more likely to be able to keep up with the payments. So, if your income is $4,000 per month and your debts are $500, this would mean that you are currently at an approximate 13% debt to income ratio.
- Now, take 36% (to be safe) and subtract the figure you arrived to above. In our example, we came to %13. So, you would subtract 13% from 36%. This would equal 23% of your income and that would be the basis of how much mortgage you can afford.
- Take your income and multiply it by the percentage number above.In our example we came to 28% and an income of $4000 a month. $4,000 x 23% = $920.00 payment with taxes and insurance would be the approximate mortgage payment that you should be able to afford.
- What would a $920 payment buy?A 30 year mortgage at 7% would place you in the $110,000-$115,000 range for the full amount you would probably be able to borrow. You have to allow room for taxes and insurance. This amount is usually around 1-1.5% of the loan amount. So, to give you an example, a $100,000 mortgage would cost approximately $1,250 a year for taxes and insurance.
- Now, simply figure out what prices and at what percentage rates are in your budget. This is how you determine whether or not you can afford a mortgage.
Remember that it is always good to undershoot the number. It is better to buy a cheaper house and to have extra money then it is to overdo it and come up short.