When it comes to mortgages, the very basic question of how much mortgage you can really afford is extremely important, and perhaps not as simple as it may appear at first glance. Although you may have considered initial costs such as your downpayment, basic mortgage costs and additional costs such as utilities and maintenance, have you really thoroughly considered how affordable your monthly payment actually is, once all factors it covers have been taken into account?
Here, we'll break down the method of working out how much you can really afford, saving you time and hassle in the long run.
- Working Out Your Eligibility
When considering your application for a loan, lenders will consider not only your down payment but also two important ratios. The first of these is the front-end ratio, a percentage of your yearly gross income which goes towards paying your monthly mortgage payments. These payments consist of four components often referred to as PITI: principal, interest, taxes and insurance. Generally, your PITI should not exceed 28% of your gross income, although some providers will allow PITIs in excess of 30% or even 40%.
The second ratio lenders consider is the backend or debt to income ratio (DTI). This is the percentage of your gross income required to cover not only your mortgage but also all of your other debts such as credit card payments, child support and other loans.
Generally, lenders recommend that your DTI does not exceed 36% of your gross income, so to calculate your DTI using this principle simply multiply your gross income by 0.36 and then divide this by 12.
- Personal Choices
One of the most important factors you should consider after working out how eligible you are for a loan is that you do not have to choose the largest mortgage available to you. Although this would allow you to get the biggest house possible and your eligibility looks good on paper, the financial reality may in fact be a lot tighter and unrealistic.
Take your DTI, for example. This is calculated using your gross income and not your net income, so after taxes the equations may not look as appealing.
An example – imagine your net income is $50,000 per year. After taxes (at 28%) you are left with $36,000 net. If $20,000 of this goes towards your mortgage, there is only $1,333.33 left per month for all other expenses, which is not a huge amount.
If your DTI should not exceed 36% of your gross income, in this case $1,500, living with only $200 to spare per month could be tricky. Unless you have a savings fund in case of emergencies and unexpected bills such as car repairs and home repairs, paying a mortgage this high could leave you on the edge financially, depending on how prudent a spender you are.
- Don't Rush
The best advice when considering how large a mortgage to take out is to not rush into any decisions. Seeing as your mortgage is probably the single largest loan you will ever take out in your life it deserves some time to think it over!
After doing your calculations, ask yourself whether you would really feel comfortable in that financial situation – everyone is different. Remember that taking out the biggest mortgage possible isn't always best, and that being house poor (i.e. short of cash because it all goes on your mortgage and property) is generally not advantageous.