You know you want to buy a house, but how much can you afford? How much money will a bank give you? Before you get too excited, understand that banks may qualify you for more than you want to spend. What you qualify for and what you need are two different things. Once you know that, you will make a more informed decision. Here we discuss what you must consider before taking out a mortgage.
What are the Rules?
First, you should know the general rules. The mortgage industry became a lot tighter after the housing crisis. The days of no verification loans are gone. Today, you must verify everything. In addition, there are strict rules in place. The rules pertain to the amount of your income that can cover your mortgage payments. Regulators want to make sure no one gets in over their head again. With that being said, most lenders follow the 28% rule.
The 28% rule means no more than 28% of your gross monthly income can cover your mortgage. Your gross monthly income is your income before taxes. For example, if you make $50,000 per year, your maximum mortgage payment would be as follows:
– $50,000/12 = $4,167 per month
– $4,167 x 0.28 = $1,167
Your mortgage payment shouldn’t exceed $1,167 according to the 28% rule.
But, there are other rules too. A big one is the Qualified Mortgage rule. This rule states that your total debts can’t exceed 43% of your gross monthly income. Total monthly debts mean your credit cards, car payments, student loans, and mortgage payments. If your mortgage takes up 28% of your income already, you only have 15% of your income left for “other bills.”
What Gets Figured Into the Payment?
Something you should understand, though, is what lenders figure into that 28% figure. It’s not just the mortgage payment itself. A mortgage payment consists of principal and interest. But, you can’t forget your real estate taxes and homeowner’s insurance. These are both required in order to have a mortgage. They become part of your monthly payment. If you put less than 20% down on your home, you may also owe Private Mortgage Insurance. If you take an FHA or USDA loan, you pay mortgage insurance as well. These numbers figure into the total payment.
Suddenly that 28% doesn’t look like very much! You have a lot of factors that go into that number. History has shown that 28% of your income is a safe number to keep borrowers from defaulting, though.
Look at Payment Shock
Aside from a percentage of your income, lenders focus on your current payments. Let’s say you pay rent now and want to buy a home. Lenders try to keep your mortgage payment as close to your rent as possible. This eliminates what they call payment shock. This means your mortgage payment is much higher than your rent payment. Even if you can afford it, that shock can be hard to handle at first. Lenders want to avoid the risk of default, so they try to keep payment shock to a minimum.
Get Compensating Factors
Compensating factors help when you need a mortgage that exceeds 28% of your gross monthly income. These are things that offset the risk a higher debt ratio causes. A few common compensating factors include:
- High credit score – Your credit score is a reflection of your financial responsibility. The higher the score, the more financially responsible you look.
- Low credit utilization rate – If you max out your credit cards you not only ruin your credit score, but you also look like a high risk. Pay off your credit cards to have a low utilization rate and compensating factor.
- Assets on hand – Lenders love to see borrowers with reserves. This is money you have in a liquid account that you can access. If your income stopped for some reason, you would have the reserves to cover your mortgage payment. Try to aim for at least 3 months of reserves to use as a compensating factor
- High down payment – The more money you have invested in your home, the more likely you are to make the payments. This is why it pays to put a large down payment down when you can.
The Loan Program Matters
Of course, the loan program you use determines how much you may borrow. Some programs, like the VA and FHA programs have more lenient guidelines. Following are the most common rules:
- Conventional loans – Typically, your mortgage payment can’t exceed 28% of your gross monthly income with the conventional loan. There are exceptions, but they must be approved by the lender. Compensating factors help in this situation.
- FHA loans – FHA loans have higher debt ratio requirements. They usually allow ratios of 31/43. This means 31% of your income can cover your mortgage. This may give you a slightly higher mortgage balance.
- VA loans – These loans are in the minority because they don’t look at debt ratios. If they do, they consider the total debt ratio which they like to keep at 41%.
- USDA loans – These loans have maximum debt ratios of 29/41 along with the requirement of buying a rural home.
Keeping it conservative, figure you can afford 28% of your gross monthly income. Anything beyond that can be considered a bonus. You don’t want to get in over your head, so minimizing your debt ratio is a great idea. If you can’t find a home for the mortgage amount 28% gives you, consider finding compensating factors to help boost your borrowing power.
Remember, lenders are going to be a bit more lenient just because of the housing crisis. They want to make sure borrowers can afford their loans easily. They also don’t want borrowers having to sacrifice in their daily living just to make ends meet. This may be a recipe for default. Keep your payment affordable and enjoy your financial freedom.