When the time is right to purchase a home, the first question you need to be able to answer is how of a home you can afford. Knowing the answer to this question will allow you to focus your search on homes within the correct price range even before applying for a mortgage.
Debt-to-Income Ratio
The most important factor that lenders use as a rule of thumb for how much you can borrow is the debt-to-income ratio. This ratio takes into account a mortgage payment plus your other personal debt you are carrying such as car loans, credit card debt and student loans. The ratio is expressed in a percentage of how much of your income is being used to make debt payments.
The typical guideline used by most lenders is a ratio of 36% as the upper limit. Ratios above this may carry a higher interest rate or be denied altogether. Lenders also like to see that generally no more than 28% be dedicated to all housing expenses.
Calculating Your Debt-to-Income Ratio
The first thing you need to do is determine your gross monthly income. This is the income before taxes and other expenses are taken out. If you are married and will be applying for the loan jointly you should add together both incomes. Then take this number and multiply it by 0.36. For example, if you and your spouse have a combined gross monthly income of $7,000:
$7,000 x 0.36 = $2,520
This means that your total monthly debt payments should be no more than $2,520, mortgage payment included.
The next step is to determine your total non-mortgage debt payments such as monthly credit card or car payments. For this example we will assume your monthly debt payments come to $950. Computing the maximum mortgage payment:
$2,520 - $950 = $1,570
From this example we have determined that the most home you can reasonably afford is one with a mortgage payment of $1,590 which would include property taxes, insurance and possibly private mortgage insurance.