Determining How Much You Can Afford

In order to determine what you can realistically spend on a new home, you need to carefully examine your current monthly income and expenses. When considering your loan application, lenders will look at your debt-to-income (DTI) ratio to aid in making their decision. The better your DTI, the more confident lenders will be that you’ll stay on track with your payments and pay the mortgage back. With a DTI less than 33%, you’ll qualify for better terms and interest rates because you represent a low risk of default. As your DTI approaches the 50% rate, you’ll see less favorable interest rates and terms to cover the potential risk to the lender. A DTI greater than 50% is considered high and an applicant is therefore unlikely to secure a loan, in which case, debt reduction should be considered before applying for a mortgage.

To calculate your DTI, divide your monthly debt obligation, not including groceries, utility bills, etc., by your total gross monthly income (before taxes). Your recurring debt obligations may include:

• Monthly rent (or current mortgage payment)
• Monthly child support payments or alimony
• Auto loans (payments and insurance)
• Student loans
• Personal loan payments
• Minimum credit card payments

Once you have calculated your DTI, consider using the 28/36 rule to determine what you can afford. According to this rule, most people can afford to spend as much as 28% of their gross monthly income on a mortgage and up to 36% on debt payments and still manage other typical recurring expenses. Some lenders may approve you for a mortgage if your finances fall outside this ratio, but they will likely charge extra fees and a higher interest rate to cover the increased risk, making your mortgage more expensive. Depending on your credit score, you may be qualified at a higher ratio.

Estimating Your Monthly Mortgage Payments

In estimating the monthly mortgage premium, be sure to consider two factors that heavily influence what you’ll end up paying for your loan, and how the monthly payments will be affected.

• Mortgage Term: Your mortgage term is the total length of your mortgage. If you have a 30-year term on your loan, you’ll make a premium payment every month for 30 years. After this period, your loan is fully matured and the lender closes your account. The most popular mortgage terms are 15 years and 30 years. Taking a longer mortgage term lowers your monthly payments, allowing you to buy a more expensive home. You will, however, pay more for your loan over time with interest charges.
• Interest Rate and Payments: The specific interest rate you’ll pay depends on a number of factors, including your credit score, your loan structure, and current market conditions. Even a difference of a tenth of a point in interest can mean paying thousands more for your loan over time, so it’s worth the effort to shop around to get the best rate possible. Interest payments go to your lender in exchange for your loan.

Factoring Additional Costs of Homeownership

Keep in mind that as a homeowner, your mortgage principal and interest are not your only expenses. Some additional costs of home-ownership include:

• Homeowners Insurance: Although it is not a legal requirement to own a home, most mortgage lenders won’t give you a loan unless you have adequate homeowners’ insurance, which protects you against damage to your home from hazards like fires, break-ins, and natural disasters. Your homeowners’ insurance rate will vary depending on your individual state and circumstances, but you can expect to pay an average of $100 per month for your premium.
• Property Taxes: No matter where your location, you must pay property taxes. Property taxes go to your local government to fund public schools, libraries, emergency services, etc. Your property tax rate will vary depending on where you live. If you’re shopping for a home in a specific county, know the effective tax rate to estimate your liability.
• Private Mortgage Insurance: If you buy a home with less than 20% down, you must pay private mortgage insurance (PMI). PMI is insurance that protects your lender if you default on your loan. PMI payments can add up to $100 or more to your monthly premium. However, you have the option to cancel your PMI once you reach 20% equity in your home.
• Closing Costs: Closing costs are one-time expenses that include appraisals, title insurance, attorney fees, etc. Expect to pay between 3% - 6% of the total purchase price of the home in closing costs.

Being a homeowner also includes variable expenses such as utilities, homeowner association dues, maintenance and repairs, landscaping, and furnishings. It is also wise to account for emergency expenses that arise, as well as savings and retirement.

Comparing to Your Budget

Now that you have determined how much you can afford, estimated your monthly payments, and factored additional costs of homeownership, it is crucial to compare it to your current household budget. If you don’t have a budget, track your household spending for a few months. Look at how a new mortgage payment would affect your savings, income, and DTI. If it seems reasonable, you might be ready to get a loan. If it doesn’t seem reasonable, and your anticipated homeownership expenses consume more than your estimated monthly budget, you'll need to adjust your mortgage choice. Taking a longer mortgage term and buying a less-expensive home are two ways you can lower your monthly payment.