You’ve decided you want to buy a house instead of renting a place. Now comes the question of how much of a loan you can actually afford. That ties directly to what kind of house will fall within your means, what part of town you can stay in, whether you need to get a roommate to help pay, and the impact it may all have on your savings.
Here are some ways to determine how large of a mortgage you can afford to take out, and still make sure that you can purchase a home that’s right for you.
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The Debt to Income Ratio
One formula lenders use to determine if they should let somebody borrow money is the debt to income ratio. Basically, they see if a person’s income can sustain their current debts along with the new loan without running the risk of not paying loans off.
To determine your current debt ratio, take all of your monthly debt payments and divide by your gross monthly income. Monthly debts can include car payments, student loans, outstanding medical bills, credit card bills, and small personal loans. It does not include regular bills like utilities, rent, cell phones or food.
The magic number that lenders will tolerate is around a 43 percent debt ratio. So as lenders look at how much to offer a person, they see how large of a loan they can give without going over that debt ratio by combining current outstanding debts with what they would lend them. If the loan is enough to purchase a home without going over the 43 percent ceiling, that person might qualify.
Remember though, that the debt to income ratio only takes into account current debts, not recurring bills or lifestyle costs. Just because you are under the debt ratio doesn’t automatically mean you can afford the mortgage.
Accounting for Your Costs
So you have your debt ratio, but now you need to account for all of your other regular bills. Budgeting and tracking where your money is going is essential to knowing if you can afford a mortgage.
For a month, keep your receipts for every purchase you make. Then, at the end, filter out the different purchases you made and find out where your money is going. It’s easy to track things like housing costs, and paying off debts, but where is the rest of your money going? How much are you spending on food, gas, frivolities and whatever else you are getting? How much of your income is going into savings?
It’s important to recognize how much money you are spending on necessities and on non-essentials. It’s likely that your mortgage and associated costs will be higher than your rent, so that extra money needs to come from somewhere. That means putting less into savings or cutting out nonessentials. The larger the mortgage, the more changes in your lifestyle you’ll need to make.
As you begin the house hunting process, you’ll want to go to a lender to make sure you can even get a mortgage loan. This is called getting pre-approved. Basically, the bank or private lender takes into account your financial situation including your savings, current income, job history, and credit history, looks at your debt to income ratio, and tells you typically how much they are willing to lend you. It’s with this basis that you know what range of homes you can afford. This may also be your first signal that you have poorer credit than you expected, and should maybe take some time to repair your credit before moving forward with the mortgage and home-buying process.
Here’s the thing about getting pre-approved though: You don’t have to get the maximum amount of the loan offered. In fact, it’s probably not a good idea to go with that amount.
The bank only looks at how much they can lend you until it becomes impossible for you to pay it back and they risk you defaulting on the loan. It’s important that even after you are pre-approved that you still do your own budget and figure out what you can afford along with the mortgage.
Additional Costs of Home Ownership
There are other costs that have to be accounted for alongside your monthly mortgage payments. For example, sometimes when you rent a place, some of the utilities will be paid for as part of your monthly rent, but in ownership, you have to pay for everything. That means paying for water, gas, electricity, sewage, trash and more. Depending on where you live, you might have to pay for things like HOA fees or extra local taxes.
With homeownership comes extra costs in living, too. While many of these expenses are one time things, like buying a new fridge or fixing a fallen fence, it’s smart to be able to swallow up these costs without having to take out extra loans on them. While there is no accepted rule of thumb, it’s smart to have enough extra income every month that some can go towards improving and fixing problems in your home — or toward saving for these inevitable expenses.
Knowing Your Limits
Buying a house is a long term commitment, and getting one with too large of a mortgage can be a major mistake you want to avoid. Especially in competitive housing markets, prices on homes can leap up in aggressive bidding wars. Before you go out and look at houses, set a limit of what you can afford with your current budget. Don’t hedge your purchase on getting a future raise or a new job. Make sure you can afford it now (and in the future) based on what your current income is.
It can be tempting to go over your limit, especially when you fall in love with a house and bidding forces the price up. Don’t be afraid to walk away from a home. But if a home falls within your limits and you are happy with it, go for it. Just be sure to protect yourself financially and don’t blow all of your money every month on mortgage payments.
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