How do lenders decide how much I can afford?
Lenders use a debt-to-income ratio to determine the mortgage amount you can afford. Many prefer to see a ratio no larger than 36%; however, some will allow a ratio between 40% and 50%.
Follow the 28/36 rule
Financial advisors recommend spending no more than 28% of your gross monthly income on housing and 36% on total debt. Using the 28/36 rule, if you earn $4,000 monthly, aim for a mortgage payment of up to $1,120 and limit other debts to $1,440. Budget the rest for essentials, leisure, and savings.
Calculate debt-to-income ratio (DTI)
Gather these two pieces of information:
- Monthly debt. Include your estimated mortgage amount, car payments, credit card payments, student loans and other financial obligations.
- Monthly household income. Add up the total amount that you and any co-borrowers earn before taxes. For example, let’s say that you earn $3,000 per month before taxes and your partner earns $3,600. Your total gross monthly income would be $6,600.
Calculate your debt-to-income ratio by dividing your total monthly debt by your monthly household income. For example, let’s say that your total debt, including the new mortgage, is $2,800. Divide this by $6,600 to get a DTI ratio of 42%. If your lender requires a DTI of 36%, this ratio is too high. But don’t worry; there are steps you can take to reduce it.
How can I decrease my debt-to-income ratio?
If your DTI ratio is too high, you can use a few strategies to lower that number and make it easier to qualify for a home loan. Consider the following:
- Pay down debt. Do you have two car payments? Would you consider selling one car and paying cash for a less-expensive car? Paying off debt can help you decrease your DTI. List all current debt, and determine which contributors to it are most expensive each month and what you can reasonably pay off.
- Consider a less-expensive house. Lowering your housing budget is a fast way to decrease your DTI through a lower mortgage payment.
- Make a larger down payment. When you make a larger down payment, you can reduce the total loan amount and consequently your monthly mortgage payment.
- Extend loan payment terms to have lower monthly debt obligations. Do you have a large car payment? Explore what happens if you refinance that loan balance into a longer-term loan to lower monthly payments. Keep in mind that extending any loan term will add up to paying more interest over the life of the loan.
- Negotiate a higher salary. Are you due for a raise? If so, now might be the perfect time to broach that subject. Lay the groundwork by offering to take on extra responsibilities and proving your worth to the organization.
Typical mortgage costs
The total cost of your mortgage extends well beyond the loan amount. A variety of costs are associated with your loan, including:
Principal. The principal is the actual amount you borrow. For example, if you borrow $200,000 to purchase a home, this is the loan’s principal.
Interest. The interest is what the lender charges you to borrow the money. For example, with a 30-year $200,00 mortgage with a 4% fixed interest rate, you’ll end up paying $143,739 in interest over the loan term. In contrast, a 15-year mortgage rate for the same amount will only cost around $66,287 in interest. If you can afford a higher monthly payment and a shorter loan term, you’ll save a significant amount of interest.
Property taxes. Property taxes are assessed by the local authority on an annual basis. For example, let’s say that your annual property tax bill is $3,500. Divide that number by 12, which gives you a payment of around $291 monthly.
Homeowners insurance. A homeowners insurance policy covers a variety of damages, such as from storms, theft, fires and more. The cost of your policy will vary based on your house details and geographic location, but the average homeowners insurance premium in the United States is $1,211 annually, or about $100 per month.
Mortgage insurance. If you make a down payment that is less than 20%, you will likely need to pay private mortgage insurance. The cost of PMI ranges from .55% to 2.25% of the original loan amount annually and is paid on a monthly basis. The good news is that once you have at least 20% equity in the home, you can request that your lender no longer require PMI.
Homeowners association fees. Homeowners association fees can vary drastically but are typically between $100 to $700 monthly. Fees vary based on what the association provides, which may include a pool, recreational areas and yard maintenance services. Just keep in mind that this fee will affect your DTI ratio.
How can I lower my monthly mortgage payment?
A mortgage calculator allows you to input different numbers to determine the best scenario for your situation. A few strategies to lower your monthly mortgage payments include:
- Extend your mortgage term. The monthly payment on a 30-year mortgage loan will be much lower than that on a 15-year term. You will end up paying more interest over the life of the loan, but this can help you drive down short-term housing costs.
- Make a larger down payment. If you make a larger down payment, you can quickly decrease your monthly payment and the interest you pay over the life of the loan.
- Monitor your equity. Ask that PMI be removed once you have at least 20% equity in your home. PMI can add hundreds of dollars to your monthly mortgage payment, and this is a simple way to reduce your monthly debt obligations.
Moving forward with confidence
If you haven’t owned a house in the past or if your circumstances have changed since your most recent prior purchase, it can be difficult to know what you can afford. A calculator can help you run different scenarios so you can make any necessary changes to accomplish your homeownership goals.