How Much Mortgage Can You Afford?
To determine how much can be borrowed for a mortgage, the lender uses several different ratios. It is important to know the criteria used to determine the loan amount, and equally important as a borrower to have an idea as to how high of a mortgage can be comfortably taken on.
- Front-End Ratio: The monthly percentage of your yearly gross income dedicated to mortgage payments is called the front-end ratio. Mortgage payments consist of four basic components: taxes, interest, insurance, and principal. Often, they are collectively known as PITI, and should not exceed 28% of your gross income. This is a general rule of thumb, although some lenders have been known to lend to borrowers with PITI exceeding as high as 30 to 40%
- Back-End Ratio: The percentage of a borrower's gross income required to cover their debts is called the back-end ratio. It is also known as the debt-to-income ratio. Debts include car payments, child support, credit card payments, mortgages, and other loan payments. Most lending institutions will recommend that the borrower's debt-to-income ratio should not exceed 36% of their gross income. Based on this ratio, the maximum monthly debt can be calculated by multiplying one's gross income by 0.36 and then dividing by 12. It may be difficult to stay within a 36% guideline in regions where the home prices are higher, although some lenders will allow a debt-to-income as high as 45%. Additionally, there are some mortgage programs, such as Veterans Administration mortgages and Federal Housing Authority mortgages that allow a ratio to exceed 36%. Bear in mind that a higher ratio could raise the interest rate, so it may be better to go with a less expensive house. It is also in the borrowers best interest to pay off as much debt as possible before even shopping for a mortgage, as it can help them achieve a lower debt-to-income ratio.
- Down Payment Percentage: Many lending institutions will let a buyer purchase the home with a significantly smaller down payment, but paying at least 20% of the home's purchase price up front will minimize the insurance required. Buyers who can make a larger down payment are able to purchase more expensive houses, and 20% or more can help buyers avoid mortgage insurance altogether. The mortgage payment is directly impacted by the down payment, and also by both back-end and front-end ratios.
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