If the term mortgage has crossed your mind recently and you’re in the market to purchase a new home, you’ve probably asked yourself, “How much house can I afford”? This is a very important question all prospective homeowners should know the answer to before they begin shopping.
In fact, if you don’t already have a mortgage pre-approval in hand, which essentially details how much you can afford, most real estate agents won’t take you seriously. And may not even take you to see listings. Why? Because sellers won’t want to waste their time with a prospective buyer that isn’t qualified.
Income vs Liabilities
The best way to determine how much house you can afford, or really how much house the lender will let you buy, is to first look at your gross monthly income, and then compare it to all your liabilities. Liabilities include anything you have to pay on a monthly basis, including both revolving and installment accounts, which show up on your credit report.
Installment accounts are typically mortgages, student loans, car loans, which have fixed terms and require regular payments. Essentially, you owe a fixed amount of money each month and have a fixed amount of time to pay it back. An example would be a car lease that has terms of 3 years at $200 a month. Each month you pay $200 and you must pay off the entire balance by the end of the 3 years.
Revolving accounts, on the other hand, offer more flexibility. These include credit cards that allow you to pay a minimum monthly payment, which you can also keep a balance on. Though you may have a preset spending limit, your balance can vary month-to-month, and thus your minimum payment can change as well.
You have the choice to pay the minimum payment, or a larger amount. You can even pay the entire balance off if you so desire. When calculating your revolving accounts, simply take the minimum payment due.
Get a Credit Report
The next step is getting your hands on a credit report so you can see exactly what each payment looks like for each liability as reported by the credit reporting agencies. This is important because though you may pay a certain amount monthly, the amount can change and will vary upon different credit reporting methods, so it’s best to view a credit report to see exactly what the credit bureaus see. This is what lenders will see.
Also be sure to take into account any monthly payments you make that won’t show up on your credit report, such as gardening services, pool services, and cleaning services to name a few.
*An important note to keep in mind! If you pull credit on your own or with a mortgage broker, the bank or lender you use for financing will still pull their own credit report, and any new activity will likely show up on their report.
This is why it is imperative to avoid opening any new credit cards and/or avoid making any expensive purchases on existing credit cards before and during the home-buying process. Doing so can throw off payments and drop credit scores dramatically if you accrue a large amount of debt or open any new lines of credit between when you pull credit and the bank does.
Figure Out Your Debt-to-Income Ratio
Once you tally up all your monthly payments and divide the total by your gross monthly income, you can figure out exactly how much house you can afford by calculating your DTI, or debt to income ratio. Banks and mortgage lenders have certain DTI ratio requirements that you cannot exceed.
For example, you may see something like 30/45, meaning your monthly housing payment (mortgage payment plus taxes and insurance) cannot exceed 30 percent of your gross monthly income, and your housing payment plus all other monthly liabilities cannot exceed 45 percent of gross income.
Keep in mind that this is a lender requirement, but you should also determine how much house you’re comfortable with financing. For instance, you may want to sock away a certain amount of money each month for savings, retirement, or your child’s college education. So be sure to look at both the lender’s numbers and your own comfort level.