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How Much Can You Afford for a Mortgage?
Every lender has a formula to tell how much a person can afford in mortgage payments. Formulas are good because they can give a definitive number. However, most formulas do not factor in a person's lifestyle (what is important to that person), future financial down-turns, or what each person feels comfortable paying for housing.
COMMON DEBT-TO-INCOME RATIOS
Mortgage lenders loan money based on a set of criteria. That criteria rates the property, the neighborhood, the building, and the borrower. This chapter will explore the common criteria used to rate the borrower and how you can use that information to make decisions before you ask for a mortgage.
Lenders usually use a two-part ratio calculation that sets the boundaries of what you can pay for a home. This is currently expressed as the 28/36 formula (but the exact numbers may change by the time you read this).
The first part, the front-end ratio or the housing-to-income ratio, is the total mortgage payment divided by your gross monthly income. The percentage result should be somewhere in the 28% to 33% range. Right now 28% is currently used by the majority of lenders. Depending on your credit history, amount of debts, and amount of potential future income, your lender may change the front end percentage.
The total mortgage payment or housing costs includes: monthly loan payment, real estate taxes, home owners insurance, mortgage insurance (if any), and association fees (if any).
Gross monthly income is what you receive each month from every source. This income total is before taxes or any deductions (such as deductions for your 401(k) program) are taken out.
The second part, back-end ratio or total debts ratio is the percentage of your gross income that can go towards all of your monthly debt. In the 28/36 formula, a person should not pay more than 36% of his or her monthly gross income for all debts.
Again, gross monthly income is what you receive each month from every source. This income total is before taxes or any deductions (such as deductions for your 401(k) program) are taken out.
Monthly debt includes payments on credit card debts, loans, alimony, child support, plus housing costs, but does not include household expenses like utilities, food, clothing, and the like.
Monthly housing costs are mortgage payment, real estate taxes, home insurance, mortgage insurance, and association fees.
HOW TO USE THESE RATIOS
So, you are probably looking at these ratios and saying "How does that affect me? All I want to do is to get a mortgage without the hassle of dealing with math equations." Not only do I understand, I feel exactly the same. These ratios were created and are routinely used by lenders, you know, those people who enjoy working with numbers. For the rest of us, these ratios can give us an approximation of what we can afford in a mortgage and for our total debt.
While we can use the ratios like the lenders (as guidelines and generalities to determine if someone qualifies for a mortgage loan), there are two important pieces of information on ratios. First-the ratios can vary by lender, by type of mortgage, and by what the economy is doing. Second-lenders do not only use these numbers. Other factors such as your credit history, the size of your down payment, the cost of the home, the appraised value of the home, and other facts about you and the property go into the decision to issue a mortgage.
This can be better explained through examples. Let's follow two potential home buyers as they wade through the ratios. (We will also see how numbers can be deceiving.)
Janet is single. She works as a computer programmer making $42,000 per year. Her gross monthly income is $3,500.
According to the 28/36 formula:
Gross monthly income x 0.28 = Total monthly housing expense
$3,500 x 0.28 = $980
Or, in words, Janet can afford a $980 total monthly housing expense. (Remember that total monthly housing expense includes the mortgage payment, plus homeowners insurance, plus real estate taxes, plus any mortgage insurance payments or association payments.)
Looking at Janet's debts:
Gross monthly income x 0.36 = Total monthly debt expense
$3,500 x 0.36 = $1,260
This shows that Janet's total monthly debts should not exceed $1,260. Again, remember that this does not include those pricey household expenses such as utilities, food, clothing, transportation, and other living expenses.
Looking at Janet's monthly debt, she is paying $150 a month on credit card bills and $100 a month on a student loan. If you add the $980 of a total mortgage payment plus the $250 a month on debts, Janet comes up with a total of $1,230 in obligations. This is $30 less than the maximum debt obligation that the 28/36 ratio allows.
So Janet should be approved to get a mortgage from the lender that uses this ratio. Or should she? The numbers look great, but what if the credit history is not so good? Janet's employment history may be spotty. She may have had several jobs in the past 15 years, never staying longer than two years at each job. Janet's employer may have publicly announced that they are closing. So, Janet may not automatically get the mortgage loan she wanted.
What if Janet's credit worthiness is ok, but the property she wants has problems? Maybe the house is in terrible condition and did not appraise for the amount she is asking the bank to loan her? Janet may not be able to get the mortgage she wanted on that property.
These two scenarios show that although a person can be within the 28/36 ratio, there may still be problems obtaining a mortgage. In both of these cases, Janet may have to provide a larger down payment or she may have to select another property. On the other hand Janet, like many of us, may not feel comfortable with a $980 monthly mortgage payment. She may be planning to buy a new car, plus a house full of new furniture.
So how does the 28/36 ratio relate to real life? These numbers are merely maximums. This ratio says that Janet should not take on a total mortgage payment of more than $980 and that she should not have total debt of more than $1,260. So, if Janet can come up with a sizable down payment, or look for a house with a lower total cost, she may be able to get that total monthly mortgage payment down to around $600. This would allow her to go into more debt on other items.