If you are in the market to buy a new home, you may be wondering just how much mortgage debt you can afford to take on. There are literally dozens of different mortgage calculators online that you can use to run various scenarios, but you may find it more helpful in your decision making process to understand how these calculators actually work.
The Basic Calculation
Most lenders today will use a calculation known as your debt-to-income, or DTI, ratio. This ratio essentially is calculated as follows:
Debt-to-Income Ratio = Monthly Debts / Gross Monthly Income
For your monthly debts, consider such items as the new mortgage payment, car loans, student loans, credit card loans, and other debts. Keep in mind that expenses like food, childcare costs, utilities, and so forth are not included in this calculation. The figure for “Gross Monthly Income” will include your salary, bonuses and overtime, other sources of income such as rental income or royalties, and alimony. Most lenders want to see a debt-to-income ratio below 36%, and many have a requirement of around 28% for the mortgage payment alone.
Determining Your Maximum Loan Amount
The above calculation can be used to determine how high of a monthly payment you can afford to make. However, the monthly payment calculation will vary depending on factors like your interest rate and loan term, in addition to the sales price.
Debt Affordability
Many home buyers in previous years would work with a mortgage professional to fine tune the numbers and buy the largest or most grand home they could afford based on these underwriting calculations. Often this involved factors such as adjusting the loan term, buying down the interest rate, and choosing an adjustable rate mortgage with a lower initial rate over a fixed rate loan. In recent years, however, more emphasis has been placed on debt affordability. To make a loan more affordable for you over what will likely be many years of ownership, you should also factor in the expense of savings into the above calculation. Savings can be used to establish an emergency fund, to pay for college for your kids, for retirement, and more.
Keep in mind that even if the lenders do not include debt affordability in their own calculations, responsible home buyers should are take a closer look at their own plans for the future and should account for their own savings goals for the future before committing to long term mortgage debt. There is no right or wrong answer for how much you should be saving, but rather this will be based on your own plans for the future.
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