Getting ready to purchase a new home brings up a serious question for most people. How much can I afford to pay for the home of my dreams? This isn’t an easy question to answer. It depends on a variety of issues that are different for almost everybody, and there are no steadfast rules that say this is what you should pay for a home, and no rules prohibiting you from spending more than an allowed amount. One of the reasons for the difficulty in determining a maximum mortgage loan amount is that lenders and home buyers may see things differently, and use different methods to calculate a high-point for mortgage affordability.
Both ways of calculating how much home you can afford begin with using current mortgage rates. Here is a breakdown of both methods, so you can decide which is best for you.
1ST METHOD: BANK DTI METHOD FOR DETERMINING MAXIMUM MORTGAGE AFFORDABILITY
As a home buyer, you can ask the bank to calculate a maximum loan amount for you. This will give you a fair idea of what price range you can look for in a home, and have a reasonable expectation of getting a mortgage to buy it. This calculation does not use a particular price for a home already chosen. Instead it gives you a broad overview of your financial ability to purchase a home based on income, debt and what the highest mortgage affordable for you will cost on a month to month basis. All of the figures must combine in a way that does not make your DTI go above a limit considered safe for economic feasibility.
DTI is an acronym for Debt to Income Ratio. There are two parts to the DTI. The first is the front end. This calculates expected financial obligations on a mortgage amount including interest are added together. The common obligations include: real estate taxes, monthly principle payment on a mortgage, interest, home owners insurance and possible association dues. Lenders attempt to keep the front end total amount 28% of a buyer’s total monthly income. It is possible for a buyer to get a mortgage for more than 28% of their monthly income, but it is more difficult.
The second part of the DTI figures is known as the back end component. The back end takes all of a buyer’s financial obligations into consideration to figure out a percentage ratio of debt. The total combination of debt of the back end DTI takes the following into consideration:
• Monthly mortgage payment from DTI front end calculations
• Monthly auto loan or lease payments
• Total monthly minimum payments on credit card debt
• Outstanding loan payments on other properties
• Child support or alimony if applicable
You will notice that the above financial obligations do not include living expenses such as utilities or food. The banks want to know what you are legally obligated to pay to other lenders along with the loan they will be offering you. The above back end DTI figures should not exceed 36% of your total monthly income. Depending on the age, size and value of the home in question, some lenders may allow up to 45% of a buyer’s monthly income to be used to purchase more valuable properties.
2ND METHOD: CALCULATE YOUR MAXIMUM MONTHLY MORTGAGE AFFORDABILITY BASED ON HOUSEHOLD BUDGET
For some home buyers, it makes more sense to decide for themselves how much they can afford to spend on a home. While using your own figures does not allow you to go beyond the DTI percentages when you apply for a loan, it will give you a good idea of what will be comfortable to spend on a home. Banks do not take into consideration all of the minor expenses you may deem necessary to a quality lifestyle such as money needed to eat out or go to a movie several times a month. Banks also do not look at how much is spent on food or common lifestyle necessities like internet service or utilities. Many of these things, banks consider expendable and something you can do without if you need to spend more for a home. When you use your own budget to consider a maximum amount, you can decide for yourself what is, or is not necessary to live the way you want to and still pay for a home.
With this method, if you determine your regular monthly income amount minus all of your necessary expenses still allow you to pay up to $2,500 a month on a mortgage, including all of the extenuating obligations of a mortgage including interest and insurance, you can figure out a total purchase price. To do this, you need to work backwards in calculating the interest payments. If you assume a 30-year mortgage at today’s 4% interest rate, the math reveals an ability to purchase a home of up to $385,000. Using this method is a very effective way to decide how much you can truly afford to spend on a home.