Buying a home is an exhilarating experience, but it’s far from easy! One of the trickiest issues to address early on is ‘how much mortgage can I afford?’ Without knowing your numbers, you run the risk of overspending and struggling to pay your mortgage payments in the future.
With that in mind, let’s take a look at how you can figure out what you can take on.
Understanding Your Debt-to-Income (DTI) Ratio
When applying for a mortgage, lenders will be interested in several things. Your credit score is a significant factor, but most importantly, they’ll want to delve into your debt-to-income (DTI) ratio. This is an essential figure to understand, as it is the basis from which lenders will calculate the amount they’re willing to lend you.
DTI is calculated by taking your gross income (before taxes) and subtracting your current and future debts. Current debts include everything from credit cards and car loans to student loans and any personal loans. Future debt will take into account mortgage payments, as well as home insurance, mortgage insurance (if applicable) and property taxes.
Know Your Magic Numbers: 28 and 36
On the whole, most lenders will avoid anything over 43% debt to income, as this doesn’t allow a comfortable margin of error. In case of unexpected expenses, borrowers at this level are more likely to miss payments. Some lenders will accept 43% but typically levy very high interest rates.
Ideally, your housing costs should make up no more than 28% of your gross income. Meanwhile, total debts should make up a maximum of 36%. Lenders are more comfortable with figures like these since there’s a larger margin of error in case things go wrong. The greater the margin of error, the better interest rates you’re likely to be offered and the more mortgage you will be able to afford.
Calculating your own DTI is fairly easy and will give a good idea of how likely it is that lenders will approve your loan. To calculate 28% DTI, simply multiply your income by 0.28. The resulting figure will show the maximum you should be spending on mortgage payments, home insurance and property taxes each month.
- eg. $5,500 (gross income) x 0.28 = $1,540 to spend on mortgage, etc.
Multiplying your income by 0.36 will let you know how much you can spend in total to hit a DTI of 36%.
- eg. $5,500 × 0.36 = $1,980 to spend on total debt
By subtracting the 28% from the 36% figure, you’ll see how much you can spend on debts besides mortgage payments each month. Ideally, this figure should more or less match what you’re already spending on debts such as car payments, credit cards and student loans, etc.
- eg. $1,980 (36% DTI) — $1,540 (28% DTI) = $440
Don’t Forget the Upfront Costs
It’s important to remember the upfront costs of buying a home, as well as the monthly mortgage payments. Take into consideration the following:
- Down payment: for a conventional loan, 3% is the minimum you’ll need to put down. However, down payments over 20% aren’t subject to mortgage insurance. This can reduce monthly payments considerably and enable you to gain more equity quicker.
- Closing costs: you can typically expect to spend between 3 to 6% of the purchase price on closing costs, sometimes adding up to more than $10,000.
- Moving costs
- Maintenance and renovations
While this short list covers the basics, you could have more or fewer fees to pay when buying your home. The most important is the down payment. Putting down a larger sum can reduce your monthly fees, allowing for a larger mortgage. In many cases, it can pay to wait until you’ve saved up more for your down payment.
Buying Below Budget
The best thing to do is to avoid straining your financial limits. If you can find a home that would require you to spend less than 26% of your income, it’s not a bad idea. This leaves you with more cash reserves for renovations and maintenance but also enables you to bid up in case of a bidding war. It also provides you with a larger financial cushion in case of unexpected costs.
It’s always good to be able to put aside savings, and at any one point, it’s well worth having at least three months’ worth of payments in reserve.
So, before you set your heart on a home, take care of these calculations to find out just how much mortgage you can afford. Knowing your numbers reduces stress and prevents heartbreak further down the line!
This article is intended for informational purposes only and should not be deemed as legal, financial or investment advice or solicitation of any kind. Before purchasing real estate or insurance, always consult with a licensed attorney, financial advisor, insurance agent and real estate broker.