As the weather warms up and millions of Americans hit the bricks in search of listings and open houses, it's useful to start thinking about how much you're willing to spend on a home.
The size of your purchase should be guided by two different figures: the amount you can qualify for and the amount you feel comfortable borrowing.
These numbers can vary significantly, but both are related to your current income and expenses. The relationship between what you earn and what you owe is known as your debt-to-income ratio (DTI). Lenders use DTI in determining the maximum amount you're qualified to borrow, but you may find that your maximum is higher than you really need.
How Do You Figure Out Your DTI?
To understand how much home you can afford, you can begin by calculating your DTI. DTI is equal to your monthly minimum debt divided by gross monthly income. Minimum monthly debt is the mandatory monthly payment for items like utility bills, car payments, student loans, and credit cards. For example, if your $6,000 credit card balance requires a minimum monthly payment of $75, then your minimum monthly debt is at least $75.
Once you have your minimum monthly debt, you divide it by your gross monthly income to obtain your DTI. For example, if your gross monthly income is $4,000 and your minimum monthly debt is $400, you divide 400 by 4,000 to get 0.10—which translates to a DTI of 10%.
Determining an Appropriate Mortgage Amount
Determining an appropriate mortgage amount is an individual decision; everyone has a different tolerance for risk. However, every borrower is subject to the qualifications set out by mortgage lenders. Most conventional lenders only accept applicants whose DTI will be 43% or less once the mortgage is taken into account. Some lenders may go higher, but such offers are often coupled with less favorable mortgage terms. In addition, DTI on FHA loan products may go as high as 50%, but will include upfront and monthly mortgage insurance premiums.
More conservative financial advisors might recommend keeping your DTI as low as 28% or 36%. A lower DTI puts you in a better position to weather unfavorable shifts in your financial condition. The higher a DTI, the more likely such a shift will lead to missed or late payments and maybe even foreclosure. Unlike the lender’s DTI qualifications—which are more objective—your personal risk tolerance, foreseeable income patterns and debt profile will be a subjective guide to the amount of debt you feel comfortable taking on. There is no right answer; however, the lower your DTI the lower your risk of default which is always a good thing.
What Other Financial Factors Should You Take into Account When Deciding How Much to Borrow?
Understanding what a lender looks for in you as a mortgage applicant is helpful in anticipating what loan amount you qualify for and can also help you see your full financial picture. Aside from DTI, you lender will look at your credit score, employment history and debt payment history. Employment history and debt payment history are pretty straightforward and can be quantified with a quick self assessment. The longer you have had your job and the less late or defaulted payments you have the more attractive you are as a mortgage application.
Credit scores, on the other hand, are nearly impossible to calculate on your own. However, everyone is entitled to a free credit score check from all three credit reporting agencies - Equifax, Experian and TransUnion. Checking your credit before you start house-hunting is a good step to understanding your financial outlook. While DTI will not directly affect your credit score, credit agencies do look at your credit utilization ratio which is similar to DTI and compares all our credit card account balances to the total amount of credit you have available. The more you owe relative to your credit limit the lower your credit score. Reported late payments and defaults also result in lower credit scores.
Another important financial factor to consider is your true out of pocket expenses once the mortgage closing is complete. Calculating your monthly out of pocket expenses as a homeowner is not as simple as knowing your monthly payment. Owning a home costs more than just the mortgage.
Once you have determined what DTI you are comfortable with, make sure to include all the new monthly charges associated with the home. Those include property and school taxes, homeowners insurance, water bill, electrical, gas or oil, maintenance and upkeep. Overlooking these additional expenses can be a costly mistake and can turn a workable DTI into a stressful financial stretch.
Maxime Rieman is Product Manager at ValuePenguin. Educating and assisting shoppers about financial products has been Rieman's focus, which led her to joining ValuePenguin, a consumer research and advice company based in New York. Previously, she was product marketing director at CoverWallet and launched the personal insurance team at NerdWallet.
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