Mortgages: How Much Can You Afford?
Regardless of where you live, how much you earn or what type of house you are shopping for, as soon as you find out how much the seller is asking, your first reaction might be something like, “Wow! That’s expensive!” Your initial assessment is correct. With prices rising quickly, particularly in areas like New York and Boston, even starter homes can carry hefty six-figure price tags. Your next reaction is likely to be, “Can I afford that?”
Generally speaking, most prospective homeowners can afford to mortgage a property that costs between 2 and 2.5 times their gross income. Under this formula, a person earning $100,000 per year can afford to mortgage between $200,000 and $250,000. But this calculation is only a general guideline.
Ultimately, when deciding on a property, you need to consider a few more factors. First, it’s a good idea to have an understanding of what your lender thinks you can afford – to gain a precise idea of what size of mortgage their clients can handle, lenders use formulas that are much more complex and thorough. Secondly, you need to determine some personal criteria by evaluating not only your finances but also your preferences.
Lender’s Criteria: Debt-to-Income Ratios
From a lender’s perspective, your ability to purchase a home depends largely on the following factors:
The front-end ratio is the percentage of your yearly gross income dedicated toward paying your mortgage each month. Your mortgage payment consists of four components: principal, interest, taxes and insurance (often collectively referred to as PITI) (see Understanding the Mortgage Payment Structure). A good rule of thumb is that PITI should not exceed 28% of your gross income. However, many lenders let borrowers exceed 30%, and some even let borrowers exceed 40%.
The back-end ratio, also known as the debt-to-income ratio, calculates the percentage of your gross income required to cover your debts. Debts include your mortgage, credit-card payments, child support and other loan payments. Most lenders recommend that your debt-to-income ratio does not exceed 36% of your gross income. To calculate your maximum monthly debt based on this ratio, multiply your gross income by 0.36 and divide by 12. For example, if you earn $100,000 per year, your maximum monthly debt expenses should not exceed $3,000.
A down payment of at least 20% of the purchase price of the home minimizes insurance requirements, but many lenders let buyers purchase a home with significantly smaller down payments. The down payment has a direct impact on your mortgage payment and therefore also on both the front-end and back-end ratios. Larger down payments enable buyers to purchase more expensive homes.
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