You’ve saved up your down payment, interest rates are good, and the time is right. So how much house can you afford to buy? There is a qualifying ratio lenders look at when approving you for a mortgage.
Debt to income qualifying ratio
The place to begin is your monthly gross income. That is, your income before any deductions for taxes, retirement plan contributions, or other payroll deductions. Bottom line: for those with excellent credit, the debt to income qualifying ratio lenders look for generally fall between 40-50%. In other words, lenders divide up all your monthly debt payments (including a proposed housing payment) by your gross monthly income. The result is a percentage. Debt payments include things like housing, credit card, student loans, and car payments.
Can you handle the debt payments?
Lenders want to see how you manage existing debt. They want to know if you are a responsible borrower before approving you for a mortgage. If your monthly debt payment is below the lender’s debt to income qualifying ratio, you are much more likely to get approved for a mortgage. Contrast this with someone whose liability payments exceed 50% of gross income. In this case, you likely cannot handle a mortgage.
While a 50% debt to income qualifying ratio is the maximum a lender may consider, the reality is most home buyers won’t get approved at this percentage. For example, conventional loans use a 28% and 36% qualifying ratio. That is, you should spend less than 28% of gross monthly income on housing expenses – mortgage principal, mortgage interest, property taxes, housing insurance, and housing/condo association fees. The 36% qualifying ratio includes all housing expenses, plus all other debt payments. For Federal Housing Association (FHA) mortgages, the qualifying ratios are generally 31/43.
Whatever mortgage you get, the point is a lender wants a responsible borrower. This is not only to get approved for a loan, but to get a favorable interest rate. There is nothing worse than being house poor.
Now let’s look deeper at the total monthly housing costs. You need to have estimates for each of these numbers. If you’re purchasing a condominium your realtor should be able to give you a good estimate of the monthly maintenance fee. A good rule of thumb for new high rise construction is $0.50 a square foot. So for a 1200 sq. ft., unit monthly maintenance would run roughly $600/month. The realtor should also be able to give you an estimate of the property insurance cost. Look up your property tax liability online. There is a property tax calculator at Miami-Dade.gov. You input the purchase price and zip code, and it will calculate the tax for you, taking into account the $50,000 homestead exemption.
Calculating your mortgage payment
Let’s recap so far. Say you’ve calculated your debt to income qualifying ratio. You’re under the qualifying ratio required by the lender. From that amount you’ve subtracted out any fixed monthly payments – car, student loan, Macy’s, and Mastercard. Then you subtract out an estimate of monthly maintenance or housing association charges, and from that you subtract out proposed property taxes. What’s left is what you have available for your principal and interest payment. Go online to mortgagecalculator.org, and plug the numbers in – you’ll be able to see how much you can finance given an interest rate and payment. Add that amount to the down payment you’ve saved, and now you know how much house you can afford.
Closing costs can be 2-5% of the purchase price and are due at closing. Sometimes they can be rolled into the mortgage.
Your FICO score
FICO stands for Fair Isaac Company, which is the firm that owns the proprietary software that calculates your credit score. The higher the score, the lower the interest rate. I’ve posted a separate entry dealing specifically with credit scores.
Use a realtor and home inspector
Don’t be afraid to use a realtor – it is the seller who pays the realtor’s commission, not the buyer. By all means DO get a home inspection before you purchase. You don’t know what problems might be lurking behind the walls or below the floor tiles. A good inspector can give you estimates of these repair costs, which you can then use in your negotiations with the seller.
Bottom line – before you take on a home mortgage, get yourself in a financial position where you’re debt to income ratio is below the above qualifying ratios. Also, check out my YouTube video on how to improve your credit score and become an ideal borrower for a home purchase. To learn more about this and other foundational financial planning topics, check out the CameronDowning website. Also connect with us on Facebook, Linkedin, and Twitter.