How much of a mortgage do I qualify for?
It's one of the first things prospective homebuyers ask their lender, and it seems a simple enough question. Provided, of course, that you use the right numbers.
The Lender's Math
When evaluating a borrower’s qualifications, lenders go through several equations that consider a borrower's income and monthly obligations. The lender also plugs in an arbitrary percentage of gross income (called a debt-to-income ratio) that he or she believes all borrowers should be able to afford to pay for a mortgage and other monthly debts (e.g., car loan, school loans, minimum credit card payments, etc.).
Using the current standard debt-to-income ratio of 41%, someone with an annual salary of $84,000—gross monthly income of $6,000—could take on a maximum monthly debt of $2,460.
If this borrower also has $800 in other monthly obligations—$500 car payment, $200 student loan payment, $100 monthly credit card bill—they could theoretically support a $1,660 monthly mortgage payment ($2,460 minus $800). Therefore the rule for calculating monthly debt is
(Gross Income x 41%) – Scheduled Payments = Maximum Mortgage Payment
The Borrower's Equation
But the truth is that not all borrowers are the same. Lifestyles differ. Some families are more able to live with a tight budget and still contribute to savings.
Prospective homebuyers should start by determining the mortgage payment they are comfortable making each month. Understand that your monthly mortgage payment may include items that aren't included in a typical rent payment—such as homeowners' insurance and real estate taxes. If utilities are included in your rent, be sure to consider that these will be additional expenses you’ll take on as a homeowner.
Your monthly mortgage payment is comprised of the mortgage principal and interest, real estate taxes, homeowners' insurance and, if applicable, mortgage insurance premiums and condo fees. Principal and interest represent about 70% of the total mortgage payment; you'll also pay 1/12 of the annual homeowners’ insurance premium and property taxes each month.
Let's see how this plays out when we add it all up (and subtract, multiply and divide). Say annual real estate taxes are $3,600 ($300/month), annual homeowners' insurance is $600 ($50/month) and mortgage insurance is $100/month. That leaves $1,210 ($1,660 - $300 - $50 - $100) for principal and interest. With an interest rate under 4%, every $1,000 you borrower requires a monthly payment of $4.76. That means a $1,210 monthly principal and interest payment would allow you to borrow $254,200 ($1,210/$4.76 x $1000).
Put it All Together…
What happens if the numbers don't agree, if the amount you're comfortable with is less than what a lender is willing to qualify you for, if, as in the example above, you say $1,210 and the lender says $1,660? Trust your judgment.
While there is an old adage that you should always borrow as much as you can afford and buy as much house as you can afford, that advice has proven ruinous to borrowers who overreached during the peak of the market.
Always remember that you alone know all of your personal circumstances and what you’re comfortable in housing expenses. Never let someone talk you into a mortgage loan with which you’re uncomfortable. Pay attention to the lender’s advice and insight, but trust your judgment when adding up the numbers and taking on a mortgage. No one knows better than you what you can afford.