How Much Home Can You Afford?
Deciding just how much home you can afford can be tricky. Should you settle for the affordable bungalow nestled in the modest neighborhood or spring for the lavish three-story lakefront home in the gated golf course community?
To figure out whether or not a home falls within your means, you should calculate your debt-to-income ratio. Also known as the DTI ratio, this is simply the amount of debt you have in relation to your income. Because lenders look at this percentage to determine whether or not to accept you, calculating your DTI ratio can greatly reduce your risk of being turned down for a mortgage loan.
Obviously, the lower your DTI ratio, the better. Traditional lenders prefer a debt-to-income ratio of 36% or lower, with no more than 28% of that debt dedicated to the mortgage on your home (including the mortgage principal, interest, real estate taxes and homeowners insurance.)
The less debt you have, the more you can spend on your mortgage. Therefore, if you have little to no debt, you’ll be approved for a much higher home loan than someone with a great deal of debt.
How do I calculate my DTI?
To calculate your debt-to-income ratio, follow these three easy steps:
Step 1: Calculate your gross income. Add up your monthly salary, tips, commissions, bonuses and any other income.
Step 2: Calculate your monthly debt payments. Add up all of your recurring monthly payments, including your current mortgage (principals, interest, taxes and insurance), minimum monthly payments on credit card bills, car loans, student loans, home equity loans and any other loans you may have. (Do not include expenses such as groceries, entertainment, utilities and gasoline.)
Step Three: Divide your monthly debt payments by your monthly income. The resulting amount is your DTI ratio.
Here’s an example:
John earns $4,500 a month in salary and $500 a month in commissions, so his monthly gross income comes to $5,000.
John then spends $350 a month on his car payment, $200 a month on his Visa card, $150 a month on his MasterCard, $100 a month on his student loan and $100 a month for his home equity loan. Therefore his total monthly debt payments come out to $900.
$900 divided by $5,000 = 0.18 or 18%. This is considered an excellent DTI ratio by most lenders.
Once you determine your debt-to-income ratio, you’ll have a better idea about whether or not lenders will accept you for a home loan. However, some lenders may offer you a home loan even if you can’t truly afford the monthly mortgage. To avoid becoming “house poor,” it’s important to consider your DTI ratio and choose your new home wisely.
Before applying for a home loan, take advantage of our monthly loan calculators to estimate your monthly mortgage payment. This will help you more accurately determine how much house you can afford.
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