Before you jump into a hot real estate market, it is important to figure out which part of your income needs to be put towards a mortgage. Understanding the ways that you can lower monthly debt payments, as well as the guidelines mortgage lenders use to determine the percent of your income to put towards a mortgage, can help you purchase your dream home. Once you understand the guidelines mortgage lenders use and the steps for calculating your gross monthly income, you can return to focussing on finding that house with an open layout or a walk-in pantry you have been craving.
When you apply for a mortgage, lenders typically look at your debt-to-income ratio (DTI)–your total monthly debt payments divided by your gross monthly income (before taxes) written as a percentage. The debt-to-income ratio, or DTI, is how much you owe relative to how much you make, in particular, how much your monthly debt payments are relative to your households monthly income before taxes. Front-end DTI measures how much of your monthly gross income (pre-tax) goes to pay for mortgage payments (both principal and interest), property taxes, and mortgage insurance. The front-end ratio is calculated by dividing your monthly housing costs (mortgage payments, mortgage insurance, other miscellaneous expenses) by your monthly income.
The front-end ratio is the proportion of your annual gross income that you are free to devote to paying the mortgage every month. The 28% rule centers around something called the front-end ratio, or a borrowers total housing costs relative to his income. The total housing costs include the mortgage payments, interest, property taxes, insurance, and HOA fees, not including utilities. Mortgage lenders also look at your personal financial situation, including how your monthly mortgage payments add up to your total debt, and how much income you are expected to earn as you are paying for your home. Two criteria mortgage lenders look at to figure out how much you can afford are your housing costs-to-income ratio, known as your front-end ratio, and your overall debt-to-income ratio, known as your back-end ratio.
Lenders use your debt-to-income ratio when they are calculating how much you can afford to make each month in your mortgage. Lenders use something called the 28/36 rule to determine how much you can afford to make monthly home payments, which, in turn, determines the maximum loan amount that you are eligible to take out. Each lender will have their own threshold, but a good rough number is to get a rear-end ratio of less than 36% on all debt payments, including any mortgages you take out.
This will give you a general debt-to-income ratio, which breaks down what percentage of your total income should be going to your debt payments, including mortgage, credit cards, auto loans, medical expenses, child support, alimony, and other obligations. With a 36% model, you would want to have at most 36% of your monthly income going towards debt, including mortgage payments, as well as other obligations such as auto loans or student loans, as well as credit card payments. Most lenders agree that if you are carrying debt, like credit card bills or a car payment, no more than 28 percent of your monthly gross income should go to mortgage payments (including principal, interest, taxes, and insurance). For example, if you were buying a $250,000 house at an interest rate of 4% for 30 years, the $20,000 down payment would leave you a $1,098 monthly principal-interest payment.
As one might expect, the higher your credit score, the lower the interest rate you would typically receive, although your down-payment amount is factored in, too. The larger your down payment, and the better your credit score, the lower the PMI rate, and the less years you will need to pay it off. The size of your down payment impacts how much of the monthly payments you will have to make to cover the remainder of the mortgage; a larger down payment reduces your monthly payments, and vice versa. For example, if you plug in the amount of the mortgage, $211,238, with 20% down, and an interest rate of 4%, you will see your monthly home payment rise to $1,515 once taxes are added in, $194 is added in, and $71 is added in insurance.
Use our calculator to try out other combinations to find the right combination of mortgage amount, interest rate, and down payment that works for your budget. Once you input all of your information according to the methods you chose, our Home Affordability Calculator will tell you the maximum you could pay for a house, along with an estimated monthly payment.
You can work with a lender to make an affordability calculation based on your income and the cost of the house you are thinking about, and then estimate if you can afford it. While every mortgage lender keeps their own criteria for what qualifies as affordable, your ability to buy a house (and the size and terms of the loan you are offered) will always be determined mostly by the following factors. Many different factors go into mortgage lenders decisions about homebuyer affordability, but it comes down to income, debt, assets, and liabilities.
As you can see in our comprehensive mortgage calculator, the amount of house you can afford is truly determined by how you match income with your mortgage. The particular percentage of income that you are going to put toward your mortgage depends on your unique family budget, as well as the amount of debt you have. In other words, if you are paying $2,000 a month on debt payments, but making $4,000 each month, then you are at a 50% ratio: Half your monthly income goes toward paying off your debt.
Lenders want your DTI at a low level, between 41% and 50%, depending on what kind of mortgage you are applying for, as well as other aspects of your finances, such as credit score and down payment. Income, down payment, and monthly expenses are usually your main qualification factors for a loan, and your credit history and scores will dictate your rate of interest for the loan itself. This includes the interest rate of the principal balance each month, and your mortgage, the property taxes each year, and the payments of your private mortgage insurance (PMI).