By: Yara Zakharia, Esq.To make an educated home-buying decision, prospective borrowers must ask themselves the pivotal question "how much mortgage can I afford?" Knowing how much they can afford to spend on a home loan, including the principal and interest, is critical for a successful and remorse-free mortgage transaction. By establishing a budget for this substantial investment, home purchasers will be able to focus their search on properties that fall within their league, financially-speaking. The process of assessing one's monetary capacity to afford a certain mortgage involves the following steps:
- Calculation of the borrower's gross monthly income - The consumer adds up the monthly income derived from different sources in order to arrive at the gross monthly income.
- Determination of relationship between the gross monthly income and the monthly debt - The percentage of gross monthly income that is allocated towards payment of monthly debt is then ascertained. The debt-to-income ratio plays a key role in the assessment of how much debt a buyer can handle by comparing the latter's mortgage debt to his or her earnings.
- Determination of maximum monthly mortgage payments
- Subtraction of private mortgage insurance (PMI), property insurance, and real estate taxes from the maximum periodic mortgage payments to compute the amount that can be applied towards the mortgage
- Estimate of the home loan's size.
A good rule of thumb is that consumers can take out a mortgage that is 2 to 2.5 times their gross annual income. Nevertheless, these figures serve solely as a guideline. In general, mortgage payments should constitute 25 to 33% of a borrower's monthly gross income. One of the most commonly-implemented formulas for mortgage affordability is the 20/28/36 rule, the last two digits (28 and 36) of which symbolize debt-to-income ratios, which assist individuals to figure out mortgage payments. Borrowers make a 20% deposit and can allocate up to 28% of their gross monthly income to housing expenses, which include homeowners insurance, real estate taxes, private mortgage insurance, child support, condo fees, alimony, and mortgage payment (both principal and interest). Housing and major debt expenses such as school loans, auto loans, credit card debt, and mortgage should not exceed 36% of consumers' gross income.
To determine the maximum sum that home purchasers can borrow, lenders consider two important ratios:
1. Housing expense ratio
This indicates the amount of a borrower's gross monthly income that will be applied to the mortgage payment. Lenders divide their clients' total housing expenditures by their gross monthly income.
2. Debt-to-income ratio
This number displays the amount of a borrower's gross income that will be applied to revolving debt (i.e. credit cards) and installment, long-term debt (i.e. student or car loans).
As a general rule, to be eligible for a conventional loan, borrowers' mortgage payment must not be greater than 28-32% of their gross monthly income. For government loans such as FHA loans, the ratio is 29% of their gross income. For conventional loans, total monthly costs should not exceed 38-40% of a borrower's gross income; for FHA mortgages, the ratio is 41%. One method of calculating a consumer's housing expenditures is by comparing his or her monthly income with periodic, long-term debts. To ensure that they apply for a suitable mortgage amount, future homeowners should perform the following:
- Prioritize the real estate features desired;
- Find out how much cash they have on hand for a down payment (average deposits are in the range of 5 to 20% of a property's purchase price); and
- Test the feasibility of their home purchasing plan with a mortgage professional, who will evaluate their finances and decide whether or not they pre-qualify for a loan.
A highly-effective tool in the pre-screening phase is an online mortgage calculator, which provides a table to determine mortgage payments and affordability. Typically, any combination of the following fields needs to be entered:
- Down payment
- Monthly household income
- Type of property
- Amount of cash available
- Monthly payments
- Type of mortgage product (i.e. balloon, fixed-rate jumbo, ARM jumbo, ARM conforming, fixed-rate conforming)
- Origination fee
- Discount points
- Interest rate
Mortgage calculators enable borrowers to estimate their monthly principal payments for a variety of loan terms, mortgage amounts, and interest rates. Both monthly and yearly online amortization tables are available to prospective homeowners. Another useful resource for borrowers, realtors, and creditors is the home mortgage rate forecast, which offers indispensable guidance in the decision-making process by displaying short-term and long-term mortgage rate projections.
