How Much Can You Afford?
Debt-to-Income Ratios
To
determine your maximum mortgage amount, lenders use
guidelines called debt-to-income ratios. This is simply
the percentage of your monthly gross income (before
taxes) that is used to pay your monthly debts. Because
there are two calculations, there is a "front" ratio and
a "back" ratio and they are generally written in the
following format: 33/38.
The
front ratio is the percentage of your monthly gross
income (before taxes) that is used to pay your housing
costs, including principal, interest, taxes, insurance,
mortgage insurance (when applicable) and homeowners
association fees (when applicable). The back ratio is
the same thing, only it also includes your monthly
consumer debt. Consumer debt can be car payments, credit
card debt, installment loans, and similar related
expenses. Auto or life insurance is not considered a
debt.
A
common guideline for debt-to-income ratios is 33/38. A
borrower's housing costs consume thirty-three percent of
their monthly income. Add their monthly consumer debt to
the housing costs, and it should take no more than
thirty-eight percent of their monthly income to meet
those obligations.
The
guidelines are just guidelines and they are flexible. If
you make a small down payment, the guidelines are more
rigid. If you have marginal credit, the guidelines are
more rigid. If you make a larger down payment or have
sterling credit, the guidelines are less rigid. The
guidelines also vary according to loan program. FHA
guidelines state that a 29/41 qualifying ratio is
acceptable. VA guidelines do not have a front ratio at
all, but the guideline for the back ratio is 41.
Example: If you make $5000 a
month, with 33/38 qualifying ratio guidelines, your
maximum monthly housing cost should be around $1650.
Including your consumer debt, your monthly housing and
credit expenditures should be around $1900 as a maximum.
Calculating Your Monthly Income
When
a loan officer prequalifies you, he works backwards to
figure your maximum mortgage amount. You can do the same
thing. The first step is to determine your monthly
income. It isn't quite as easy as it sounds. Lenders
only count income they can document through paperwork.
If
you are a salaried employee, and don't earn bonuses,
it's easy. Get out your paycheck. If you get paid twice
a month, multiply by two. If you are paid every two
weeks, then you multiply by 26 (the number of pay
periods in a year) and divide by twelve. Unless you're a
teacher. Teachers don't always work year round and they
have special rules.
If
you are an hourly employee who works a straight forty
hours a week and don't earn overtime income, then it's
easy, too. Look at your paycheck, multiply your hourly
rate by 40, multiply that total by 52, then divide by
twelve.
If
you earn overtime, bonuses, or commissions -- it isn't
as easy. Lenders don't give you credit for what you are
currently earning. They average your income from those
sources over the last two years, then add that to your
regular salary or hourly monthly income. If you want a
shortcut that is usually close, get out your W2 forms
for the last two years. Add them together and divide by
twenty-four. That is your monthly income.
If
you are a teacher, a nurse, a seasonal employee, in
construction, or earn only part-time income -- you can
use that shortcut, too. Add the figures from your last
two years W2's, then divide by 24. It generally gets you
close.
If
you are self-employed or receive 1099 income, then you
need a two-year track record. Lenders go by what you
declare to the IRS as income, since that is
documentable. Since some self-employed people overstate
their expenses, this may understate your income. Look at
the Schedule C of your tax returns for the last two
years and the number at the bottom that says "profit" is
your annual income. You can add any depreciation to that
figure. Add them together and divide by twenty-four.
There
are variations and exceptions (like those who own their
own corporations) but the above should cover most
people.
Working
Backward
Once
you have calculated your monthly income, multiply it by
the back ratio for your particular loan. For generic
purposes, it is fairly easy to work with thirty-eight.
Take 38% of your monthly income or multiply it by .38.
That tells you the maximum the lender wants you to spend
on your housing costs and monthly consumer debt
combined.
Now
get out your bills and total them up to determine what
you spend monthly on debt. Do not include your auto
insurance or your utilities. Just creditors - generally,
only those items that will show up on your credit report
(and child support or alimony if applicable). For credit
cards, use the minimum required monthly payment unless
it is less than ten dollars. The rest should be fairly
straightforward.
Deduct that amount from the total the lender wants you
to spend on housing costs and consumer debt combined.
Now you know the maximum the lender wants you to spend
for housing costs, unless the figure is greater than 33%
of your monthly income (there are exceptions, of
course).
A Little
Guesswork
The
next step requires a little guesswork. If you have a
vague idea of what price you might qualify for, you can
estimate what your annual
property taxes
and
homeowners insurance might cost. From there, you can
easily calculate the monthly equivalent. Subtract those
figures from your maximum monthly housing costs total.
If
you are buying a condominium (or an area with HOA fees),
subtract out an approximate figure to cover homeowners
association fees. What you are left with is your maximum
principal and interest payment.
The Final
Step - Almost
Now
you have to go to a mortgage calculator (click
here) and plug in some numbers. In the "payment"
area, put the figure you just calculated. Plug in the
current fixed interest rate. If
you are putting less than twenty percent down, add a
half percent to the rate to allow for charges you will
pay for mortgage insurance.
Hit
the calculate button and you should have your maximum
mortgage amount. Add your down payment and you know your
maximum purchase price.
Maybe. You may have to do some fine-tuning to zero in on
the exact figure. Plus, lenders know how to "stretch" a
client a bit higher if they need it.
Advice
If
the figure is less than you expected (or need), lenders
know programs that will help "boost" you higher in
qualifying. Plus, they will do what you just did for
free, they are much more experienced at the various
nuances involved, and you will have no obligation to use
them as your lender.
All you have to do is
fill-out our pre-approval form. |
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