How much house do I qualify for? To get the best answer to that question, you’ll have to do your financial homework. At a minimum, you’ll need to know:
- How lenders decide how much to loan you
- How to determine your net worth and decide how much house you can afford
- How to improve your credit score (if necessary)
After all, there is no sense in wasting your time and energy looking at houses that are out of your price range. Let’s look at each of these areas and figure out what you need to know or do.
How Much Mortgage Can I Afford?Credit: Neil2580 under royalty free license via SXC, http://www.sxc.hu/photo/1159573Credit: Neil2580 under royalty free license via SXC, http://www.sxc.hu/photo/1159573
Can I Qualify for a Mortgage?
Potential lenders weigh risk versus reward when they decide if someone can qualify for a mortgage. They want to know how much you make and from what source(s). You must show your credit and employment history to them, and they may ask questions that make you feel uncomfortable or seem intrusive.
For example, if you collect income from a previous spouse or receive child support payments, you have to disclose that although they may or may not consider the income when evaluating your application. Cooperate with all their requests and give as much information as you can to help them make their decision about whether you can qualify for a home loan.
How Much Can I Borrow?
You furnish data about what type of credit you have, how much debt you are carrying, and how much new debt you have recently incurred. How you pay your bills each month and whether you are in arrears affects their final decision.
Once they have gathered all the information about your income and your debt, they do a calculation to determine your debt to income ratio. In other words, they need to know how much discretionary income you have each month after you have paid all your obligations.
Traditionally, a debt to income ratio of 36 percent of your gross monthly income is considered to be in the safe zone for people wanting to qualify for a loan. In addition to looking at your debt to income ratio, the lender will check to see what your credit score is.
Getting a loan approval is much easier when you have a high credit score, and high scores help you negotiate a lower interest rate on your new mortgage. Your loan officer will use all this information to decide how much you can borrow.
Avoid This Financial Trap
There is a danger for homebuyers in using the traditional debt to income ratio. The model is based on calculating a ratio predicated on one’s monthly gross income and not net income. If you expect any changes in your employment situation or life situation such as a layoff or a new child, it’s probably wiser to do your calculations based on net income to allow you a buffer of protection in case of loss or decline in your income status.
How to Calculate Debt to Income Ratios
You can do your own calculations before you meet with a loan officer to get a better idea of where you stand financial and how much mortgage you can afford.
Here’s the formula:
- Gross monthly income (GMI) x 28% = the highest amount you can afford for housing (PITI* or rent)
- GMI x 36% = the highest amount of overall monthly debt you should carry to afford your mortgage or rent payment
*Principal, interest, taxes, insurance
Let's look at an example:
Gross yearly income of $57,000 ($57,000 ÷ 12 = $4750)
GMI = $4750
- $4750 x 28% = $1330 maximum PITI or rent payment
GMI = $4750
- $4750 x 36% = $1710 maximum monthly indebtedness
Do you want to do an honest evaluation of your ability to repay a mortgage and discover how much house you can afford? If so, you need to make a budget worksheet.
Start by documenting monthly expenditures (no matter how small) and be brutally honest. After all, you are not fooling anyone but yourself. If you get in over your head and cannot afford your mortgage payment, you could end up losing your home or having to file bankruptcy.
Calculating Your Monthly Expense Situation
While the following is not an inclusive list of the areas you should look at, it is a good starting point for your research.
List your monthly expenditures for items such as:
- Vehicle maintenance and fuel
- Health insurance
- Dental, vision and other insurance
- Professional fees and dues
- Credit card debt
- Ongoing education or student loans
- Utilities and amenities such as high-speed Internet access or streaming video services
- Miscellaneous expenses such as fitness center memberships or martial arts classes
For the purposes of our exercise, let's assume your total monthly expenses equal $1052.
For the next step, total all the income you receive each month from any sources. For this exercise, we want to figure net monthly income (after all taxes and deductions) and not gross monthly income.
Finally, total up your net monthly income (NMI) and your total monthly expenditures (TME). Subtract the amount of the expenses from your net income. The resulting amount is your disposable monthly income, which you can multiply by 28 percent to find how much your PITI should be to give you a hedge of protection.
$57,000 Gross yearly salary = $45,600 adjusted net yearly income (we're assuming a 20% percent tax/deduction). Our adjusted monthly net equals $3800 ($45,600 ÷ 12).
- NMI = $3800
- TME = $1052
- $3800 - $1052 = $2748
- $2748 x 28% = $769.44
By using the net income versus the gross income, you are being more cautious (and realistic) about how much mortgage you afford comfortably. Now you can search for a home in an appropriate price range and avoid over-extending yourself in housing that may be too expensive.
In the current market with an interest rate of about 4 percent, you could borrow about 150,000 on a 30-year fixed mortgage. However, if you could put $50,000 down, you could buy a $200,000 home.
Improving Your Chances of Qualifying for a Mortgage
What can you do to cut your monthly expenses so you can afford a more expensive home? Here are steps to take:
- Consider paying off your debt. In particular, pay off or reduce high interest rate loans and credit cards.
- While you could increase your income by working more hours or taking a second job, you have to balance that option with the consequences of such an action. How will that affect your personal or professional life? Do you really want to work two (or more) jobs for 15 or 30 years just to afford a mortgage payment?
- If you really have your heart set on a high-priced home, you may have to delay your purchase until you pay down your debt, cut some optional expenses such as cable or a landline telephone or dining out, or save more.
- By making a larger down payment, you can lower your monthly payment and save on interest charges over the life of the loan.
The good news is that because you took the time to assess your financial situation, you are in a better position to make an informed decision about how much you want to pay for your new home and you can answer the question “How much house do I qualify for?” with confidence.