How Much Money Can I Afford to Borrow?
Most future homeowners can afford to mortgage a property even if it costs between 2 and 2.5 times the gross of their income. Under this particular formula, a person that is earning $200,000 each year can afford a mortgage up to $500,000.
In the end, when making the decision to acquire a property, the borrower needs to consider various factors. First, the borrower should know what the lender believes the borrower can afford and what size of a mortgage the lender is willing to give. Formulas are used to get an idea as to what size mortgage a client can handle. More importantly, the borrower should evaluate finances and preferences when making the decision. Knowing the mortgage size that can be handled also helps the borrow narrow down the playing field so that precious time is not wasted in touring homes that are out of the price range.
Debt-to-Income Ratios That Lenders Use
There are several ratios that lenders consider when determining how much money a person can borrow for a mortgage. In this, it is good to know what factors lenders consider when determining how much money to lend.
- The percentage of yearly gross income that is dedicated to making the mortgage each month is called the Front-end Ratio. Four components make up the mortgage payment, which are: interest, principal, insurance, and taxes. A general rule is that these items should not exceed 28% of the borrower’s gross income. However, some lenders allow the borrower to exceed 30% and some even allow 40%.
- The debt-to-income ratio, which is also called the “Back-End Ratio” figures what percentage of income is required to cover debts. The mortgage is included in these debts as are child support, car payments, other loans, and credit cards. The debt-to-income ratio should not exceed 36% of the gross income. How monthly debt is calculated is that the gross income is multiplied by 0.36 and then divided by 12. In areas that have higher home prices, it is rather hard to stay within 36%, so there are lenders that allow the debt-to-income ratio to go as high as 45%. A higher ratio, however, can increase the interest rate, so a less expensive home may be the better choice. It is important for the borrower to try to lower debt as much as possible before seeking a mortgage. This helps to lower the debt-to-income ratio.
- Most lenders ideally like to see a down payment of around 20% of the price of the home. Putting 20% down on your home eliminates the need for property mortgage insurance (PMI) requirements, though may lenders allow buyers to purchase their home with smaller down payments. The average homeowner puts about 10% down when they buy. Buyers with limited savings may consider looking into government sponsored housing programs requiring little or no downpayment. FHA loans require 3.5% down. Both USDA Loans and VA Loans do not have a required downpayment. The USDA program is for rural homes while the VA program is for active duty military and military veterans. The down payment also has an impact on the monthly mortgage payment and on the front-end and back-end of the loan. More expensive homes can be purchased with larger down payments.
Personal Criteria: Deciding How Much Mortgage You Can Afford
The borrower should consider personal criteria when purchasing a home in addition to the criteria of the bank when determining what kind of mortgage can be afforded. Although someone may be approved for a certain mortgage amount, that certainly does not mean the payments can be covered. The following is personal criteria to take into account along with the criteria of the lenders:
- The ability for the borrower to pay mortgage payments is dependent upon income. Questions to consider are whether or not two incomes are needed to pay bills, how stable the current job is, and how easy it would be to find another job if the current job is lost.
- The borrower must ask if they are willing to make changes in lifestyle in order to afford the home. If tightening the budget will not impact lifestyle, then having a higher back-end ratio might be the way to go. If there are little things within the budget that are too important to eliminate, it might be better to take a more conservative approach.
- The back-end ration contains most of the current debts, but there may be debts that come about in the future that are not considered in the back-end ration. Doing things such as buying a new car or boat, or a child who will attend college are things to consider.
- Then there is the borrower’s personality. Some people are more comfortable making a specific payment amount than others.
Before agreeing to a particular loan, ensure you shop around to find the best rate, as small differences in interest rates can lead to thousands of dollars of savings over the life of a loan. The following interactive table highlights current local rate information.
Money You Will Spend Beyond the Mortgage
When figuring out how much of a payment one can afford, there are other expenses that must be considered aside from the mortgage. These addition financial obligations can be:
- The maintenance of the home. There will be some maintenance during ownership of the home. Appliances break down, carpet needs replaced, and roofing goes bad. Being overextended due to the mortgage can make repairs more of a burden.
- Utility expenses are what keeps the home heated, lit up, water running, and other items such as sewer, phone, and cable T.V. going.
- If the community in which the borrower moves in has amenities, there may be Homeowner’s Association Fees that must be paid. The fees can vary based on what amenities the community is offering. Sometimes the price can be $100 per month or $100 per year.
Homeowners May Want to Refinance While Rates Are Low
US 10-year Treasury rates have recently fallen to all-time record lows due to the spread of coronavirus driving a risk off sentiment, with other financial rates falling in tandem. Homeowners who buy or refinance at today's low rates may benefit from recent rate volatility.
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