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Can You Afford a Mortgage?

Can You Afford a Mortgage?

How Much Home Can I AffordWhether you’re a first-time buyer looking for the perfect starter house, or a seasoned
pro trading up to your waterfront dream home, you are probably asking the same questions:
Can I afford this? And is this the right move at the right time?

Of course, you can use a mortgage calculator and ask the experts — lenders, agents,
and mom — but the reality is that you are the only one who truly knows whether you
can afford to buy right now. And, painful as it is, what you need to start with
is a detailed expense breakdown. Analyze what you spend — at least get a full month’s
snapshot. You’ll see where you may have wiggle room in your budget and what you
can afford for housing. (Be sure to count all those little incidental expenses like
dry cleaning and yes, those mid-afternoon Starbucks lattes count in the budget,
too!)

Sample Budget

This sample budget belongs to a single, 35-year-old woman making $68,000 per year,
renting a two-bedroom apartment. Her monthly pre-tax income is $5,667.

Monthly expenses:

Rent
$1,600
Car payment
$225
Credit card payments
$200
Car insurance
$75
Groceries
$400
Health insurance/renters insurance
$208
Electricity
$40
Natural gas
$70
Cell phone
$49
Home phone + Internet access
$72
Cable TV
$50
Gas, dining, clothes, dry cleaning, gifts, other expenses
$800
Memberships (gym, professional, etc.)
$100
Water/sewer/garbage
$0
Property tax/homeowners insurance/condo fees
$0
Alarm company
$0
Lawn
$0
Total
$3,889

How-Much-House-You-Can-Afford

The sample budget may not look like your expense snapshot, but by adding and subtracting
your personal budget items with an eye toward true monthly out-of-pocket totals,
you get a pretty good picture. Now, add in all of the expenses where the zeros are
as well as the increased cost of your monthly mortgage payment (formerly rent).
Maintenance costs like condo fees, utilities, the leaky bathroom sink that defies
a simple trip to Home Depot to fix, property taxes, closing costs, and furniture for your
new home all add to the bottom line.

Debt-to-Income Ratios

If you figure out that you can afford your projected budget, chances are you’ll
qualify for a mortgage in your range. Lenders will determine how much loan you can
afford by using something called your debt-to-income ratio, which is the ratio of
a borrower’s total debt as a percentage of their total gross income. Basically,
they will look at what’s left in your budget after your monthly bills are paid.
These include credit card payments, car payments, child support, etc.

  • Housing ratio (or “front-end ratio”): Lenders want your total mortgage
    debt (called PITI — an acronym for Principal, Interest, Taxes, and Insurance) and
    condo fees to be no more than 30 percent of your gross monthly income; 28 percent
    is standard.
  • Overall debt ratio (or “back-end ratio”): These are revolving monthly
    payments, such as credit card, car lease, or loan payments, student loans, child
    support, alimony, monthly utilities. (They do not include those lattes, but you
    might want to plug in your lifestyle expenses for your own sake.) The ratio should
    not be more than 36 percent.

Debt-to-income ratio standards differ from lender to lender, and vary based on your
loan program, but most lenders will give more weight to your
credit history
as a factor in determining your particular situation. Here
is a typical ratio for a first-time buyer:

Monthly gross household income:
$5,700
Mortgage debt ratio:
28% $1,596.0
Expenses and overall debt:
36% $2,052.0

The mortgage debt of $1,596 is right in line with the current monthly rent payment
in the example above. As long as the monthly debt obligations and household expenses
are no higher than $2,000-2,300, this borrower should have no problem qualifying.

If your credit is stellar, you will be rewarded. Lenders may stretch these ratios
to 38/45, allowing you to purchase more home and take advantage of more lending
programs. And if you are a first-time home-buyer applying for an
FHA or VA loan
, you may also be able to qualify with a higher back-end ratio
— up to 41 percent of your monthly gross income — and get approved for these federally-insured
loans.

How It Works

So, back to the question: How much home can I afford?

Keeping in mind the variables on debt-to-income ratios and the many lending programs
available, here is a sample breakdown for a mid-range home.

Monthly gross household income (pre-tax):
$7,000
Mortgage debt ratio
28% $1,960
Home price
$350,000
20% down payment
$70,000
Mortgage
$280,000
Interest rate on 30-year mortgage
6.33%
Mortgage payment (principle and interest)
$1,739

Here is an example of a lower price-range home, purchased with the same loan terms
and interest rate:

Monthly gross household income (pre-tax):
$3,600
Mortgage debt ratio
28% $1,008
Home price
150,000
10% down payment
15,000
Mortgage
135,000
Interest rate on 30-year mortgage
6.33%
Mortgage payment (P&I)
$838

And the Other Costs…

In addition to the monthly mortgage payment, remember to factor in the added costs
of home purchase and ownership. Since this buyer above did not put 20 percent down,
he will need to add mortgage insurance, also known as PMI, to his monthly payment.
PMI protects lenders against losses that can occur when a borrower defaults on a
loan, and is required for borrowers with a down payment of less than 20 percent
of the purchase price. Buyers also incur closing costs of 2.5 to 3 percent of the total
loan amount. This covers the cost of title searches, appraisals, legal fees, etc.

So what’s left to apply to the down payment? Using the example above, our first-time
buyer has $15,000 for the down payment on a $150,000 home, and the closing costs
may come to $4,500. The mortgage total just increased to $139,500. Over the 30-year
loan period, this brings the mortgage payment to approximately $866 per month. If
your head is not already spinning, now tack on mortgage insurance (fees vary based
on the loan), homeowners’ taxes and condo fees (if applicable), bringing the total
monthly payment to approximately $1,038. The good news is this is still well in
the range of the acceptable debt ratio.

Keep Some Money in Reserve

Many buyers invest every red cent they have into their new purchase, but it’s a
good idea to keep some emergency cash, or “leaky faucet money,” aside in the event
of emergency repairs or a job loss. So don’t completely raid your savings; with
home ownership, expect the unexpected.