Each quarter we feature a mortgage lender answering some of the most commonly asked questions about purchasing and refinancing a home. If you’d like to submit a question for this column, email firstname.lastname@example.org.
"How Much Home Can I Afford?"
Purchasing a home seems to be a rite of passage into the adult phase of life in our culture. But, how much home can you afford based on your existing income and debts? Deciding to purchase your dream home takes much consideration and planning. To determine how much of a home you can afford, you need to calculate your expected monthly payment.
Most of your payment will go toward loan principal and interest. However, your monthly payment is also likely to include amounts for property taxes and homeowner's insurance. If you plan to make a down payment of less than 20% of the home purchase price, you will also have to add an additional amount for private mortgage insurance (PMI). Lenders require PMI to insure against the higher risk of default that occurs with loan-to-value (LTV) ratios greater than 80%.
After you calculate your monthly payment, you should calculate your housing and debt ratios. These ratios help you to get an idea of home affordability. Lenders rely on these ratios to help in their decisions to approve mortgage loans.
Your housing ratio is your total monthly payment divided by your monthly gross income. Generally, the ratio should not be more than 28%. For example, if your monthly payment is $1,650, your monthly gross income should be at least $5,892.
Your debt ratio is the sum of your mortgage payment and any other credit card or loan payments, divided by monthly gross income. Debt ratio will obviously be a higher percentage, since most people have other loans or credit card debt. Generally, your debt ratio should not be more than 36%. In this example, with monthly gross income of $5,892, your total loan payments (including the proposed mortgage loan payment) should not be more than $2,212.
How much of a home you can afford also depends on the amount of down payment you have saved. If you don't have one saved, consider these alternatives:
- Federal government mortgage-financing programs. The U.S. Dept. of Housing and Urban Development (HUD) and Dept. of Veterans Affairs (VA) run loan programs for first-time homeowners and veterans of the armed forces. These programs require little or no down payment.
- Obtain private mortgage insurance. Private mortgage insurance, discussed above, allows you to make a down payment of as little as 5% of the home purchase price.
- Borrow against the value of your investments. Some financial institutions offer mortgages that are backed by the value of your investments. With these programs, your investment portfolio serves as the collateral for your mortgage.
- Borrow from your employer-sponsored retirement plan. Most employers allow you to borrow against the value of your 401(k) plan. (The IRS does not allow you to borrow from an IRA, however.) Remember that if you leave your job, you'll likely have to pay back the full amount of the loan immediately.
- Withdraw funds from an individual retirement account. While the IRS does not allow you to borrow from an IRA, it does allow penalty-free withdrawals of up to $10,000 for first-time homebuyers. However, you will owe income taxes on the amount of the withdrawal.
- State government housing programs. Most states have programs to help residents buy their first homes.
In addition to a down payment, you should expect to pay closing costs on your home loan. Throughout the home financing process, there are many people involved to make sure that the home you’re buying is a sound investment for both you and the bank. Everything from your past credit history, to appraisals, to documentation preparation need to be in order.
Your lending officer will work with you to find the option that best works for you. But no one knows your financial situation like yourself. Being conservative in your projections of what you can afford is better than finding yourself in a position of being overextended. Be realistic in how much of your income you want to commit to a mortgage payment each month and still allow for the opportunity to save for your future.