Homebuyers taking on risky mortgages were a major cause of the housing collapse that helped lead to the Great Recession. During its peak, the Mortgage Bankers Association estimated that every three months, roughly 250,000 homeowners entered into foreclosure. While you might be tempted to trust the advice of your mortgage broker or lender, your best bet to avoid a financial disaster is to fully understand what constitutes a reasonable mortgage given your financial situation and lifestyle before you purchase a home.
Before you start home shopping, make sure you understand the total mortgage burden you can afford. A common rule of thumb is that your home purchase should not exceed more than 2.5 to 3 times your annual salary. A one-income family making $75,000 per year could reasonably spend between $187,500 and $225,000 on a home. A family with two incomes of $75,000 each could spend between $375,000 and $450,000. Use the number you come up with as a general guide only, as your debt load and current interest rates can adjust that number up or down slightly.
Housing Expense Cap
Mortgage lenders use a standard ratio, called a front-end ratio, to calculate how much you can afford to spend on housing. According to these standards, your housing expense should not exceed 28 percent of your gross monthly income. If your annual salary is $75,000, or $6,250 each month, most lenders will allow up to $1,750 each month for you to spend on your mortgage principle and interest, property taxes and insurance. Perform your own calculation by multiplying your annual gross salary by .28, and then divide that number by 12.
Your overall debt load is also a consideration when considering how much you can spend on a home mortgage. Most lenders will allow an additional 6 percent of debt expenses above and beyond the 28 percent housing expense. This includes credit card debt, student loans, installment loans, child support or alimony payments, car payments and any other recurring payments you may owe. If you have a higher debt load, you may have trouble securing a mortgage, even if your total debt is well within the ratios. For someone who makes $75,000 annually with housing expenses of $1,750 each month, they have no more than $500 per month in additional debt.
Although most lenders adhere to the 28/36 ratios, there are some that will allow you to have higher debt ratios. The Federal Housing Administration allows borrowers to spend up to 29 percent on housing and 41 percent on total debt; VA loans sponsored by the U.S. Department of Veterans Affairs does not maintain a maximum housing expense, but limits overall debt to 41 percent. Taking on a higher level of debt, however, is a very personal decision that will depend on your individual circumstances.
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