It seems so obvious -- don't take on more mortgage than you can afford. However, given the mortgage meltdown that crippled many American homeowners, it bears repeating. From your standpoint, it makes little sense to stress yourself out as you try to make ends meet month after month. And, increasingly, banks scrutinize exactly how much money you make and how much you pay out every month before taking a chance on you and approving a mortgage loan.
On the Front End
Scrutinize yourself before your bank scrutinizes you. Know your debt-to-income ratio before deciding to seek a home loan. Understand what it means not only to your bank's underwriters, but to your ability to handle a house payment. First, consider your front-end debt-to-income ratio. Take your monthly gross income -- that's how much you take in before taxes. Multiply this number by 0.28 or 28 percent. You should not commit more than the result to a mortgage payment, including the principal, interest, taxes and insurance. For instance, if your monthly gross income equals $5,000, the maximum mortgage payment you should commit to is $1,400. It's unlikely your bank will approve you for more, though this varies by lender.
On the Back End
Tally up all of your monthly debt payments, including the anticipated mortgage. Debt payments include credit cards, student loans, auto loans and personal loans. Multiply your monthly gross income by 0.36 or 36 percent. In the case of $5,000 in monthly earnings, your result equals $1,800. Your bank does not want to see total debt payments that exceed 36 percent of your monthly income. You should not want to see this either, if you're really concerned about affordability. Some banks accept a back-end debt-to-income ratio as high as 41 percent.
Your bank takes into account your personal circumstances. You should too. For example, if you have a million bucks in the bank, your bank might let you slide on an inflated debt-to-income ratio. On the other hand, if your debt-to-income ratios are low, but you know that you enjoy the high-life -- lots of eating out, frequent vacations, limos, trips to the salon -- then your real monthly expenditures, aside from debt, might get in the way of comfortably affording a house.
Radio host and financial expert Dave Ramsey takes a relatively extreme stance on evaluating how much home you can afford. First, he advocates not even thinking about buying a home until you have an emergency fund equal to three to six months' worth of expenses set aside and you are completely debt free. He also thinks you should pay for your house in cash, up-front. If you can't, he recommends no less than a 10 percent down payment, in addition to the aforementioned emergency stash. Ramsey argues in favor of 15-year mortgages and contends that you should limit your mortgage payment to no more than 25 percent of your monthly tax-home pay. This counters most other pieces of expert advice, which use higher percentages against pre-tax, not after-tax earnings.
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