One of the major problems in the mortgage industry today is, most potential home buyers over estimate how much home they can afford. I will discuss how your bank evaluates your income and how you can use what the banks use to figure out how much you can spend.
The two major ratios that banks use to determine how much you can afford are the debt to income ratio and the housing expense to income ratio. The later is calculated by dividing your estimated monthly housing payment by your gross monthly income. Your estimated monthly housing payment includes the payment of principal, interest, taxes and insurance. This number is expressed as a percentage.
Your debt to income ratio is similar to the housing expense to income ratio, except it includes all your reoccurring debt. This includes credit cards, auto loans, child support, and any other debts which have a monthly payment. Most lenders, for conventional loans, those which are not government sponsored want a debt to income ratio under 38% and a housing expense to income ratio less than 30%. However, these numbers are only guidelines. Many compensating factors, such as net worth, credit score, and the ability to make a large down payment will allow for higher ratios.
The other factors you need to consider are your down payment amount and closing costs. Your down payment is mostly your decision and should be based on how much you feel comfortable with. One of the benefits of a large down payment is you the lower your loan amount to value ratio, the lower your interest rate will be. The loan to value ratio is calculated by dividing the total loan amount by the appraised value of the home (or the sale price, whichever is lower). If your LTV is over 80%, you will need private mortgage insurance, which will add to your monthly payment. Your closing costs usually add up to about 2% to 3% of the sale price. Closing costs are paid at the close of escrow and is due on top of your down payment.
Now let’s do an example. Say you, the buyer, make $15/hour and you work 40 hours a week. To find your gross monthly income (income before taxes) we will multiply your hourly wage by your hours per week then by weeks in a year and finally divide by months in a year.
$15 X 40hours = $600 per week
$600 X 52weeks = $31,200 per year
$31,200 / 12months = $2,600 per month
Your gross monthly income is $2,600
Let’s apply the 30% rule to your housing expense to income ratio.
$2,600 X .3 = $780
This means, to have a hosing expense to income ratio of 30%, your maximum monthly house payment cannot exceed $780.
Now let’s do the same for your debt to income ratio, DTI. Say you have an auto loan which you pay $150 per month, a credit card with a minimum payment of $50 and no other reoccurring debt. If we add that to your $780 house payment, we get $980.
$980 / $2,600 = .38 or 38%
As you can see, you would meet the guidelines for the ratios. However, if you had more debt, say child support, you would not qualify and you would probably need an extensive down payment or impeccable credit to get the loan.
Now we can find out how much you can spend on the house. Say market interest rates are at 5%, using your $780 per month payment with a 30 year fixed rate mortgage and a financial calculator; we find your maximum loan amount to be about $145,000. Now that you know how much of a loan you can get, you just need to figure out how much of a down payment you can make. This completely depends on your comfort level and your funds available. Most banks like an 80% loan to value ratio, and you should too. Because private mortgage is required for any loan with a LTV of over 80%, you can save a lot of money by paying more up front. Therefore, if you use an 80% LTV, you can buy an $180,000 house. If you can’t manage to make the large $35,000 down payment, you can always have a higher LTV and just pay mortgage insurance.
This just briefly touches on how banks determine what you can afford, but it is good to know. If you have more questions about what I presented here, feel free to leave a comment or give us a call at (800) 741-3710. I’ll have a new article for you next week and I will definitely be touching on this subject again.