Taking out a mortgage is one of the biggest financial decisions you'll ever make. It involves the bank asking all sorts of questions about your income and savings to determine:
- If you make enough money to pay them back.
- If you've been trustworthy in the past (based on your credit history).
- If you have something of value to trade, should you be unable to pay them back.
In financial parlance, you've just been introduced to the concepts of income, creditworthiness, and collateral -- the three main factors that go into the lending decision.
How Lenders Calculate What You Can Borrow
To determine the maximum mortgage amount they'll approve, lenders use two income- and debt-related ratios to calculate how much you can reasonably afford each month. They will base the answer on the lower of the two payment amounts.
The front-end ratio: Basically, this is the amount of your expected mortgage payment (including taxes and insurance) divided by your income.
Generally, lenders want this ratio to be 28% or less, but there are exceptions (e.g., if the home is in a high-cost-of-living area like New York or Hawaii).
The math: (Your Annual Salary x 0.28)/12 (months) = Maximum Allowable Housing Expense
If you make $60,000 a year (that's $5,000 a month), a 28% front-end ratio means you can afford a mortgage payment of $1,400 a month.
The back-end ratio: This is the total of all of your debts, including your expected mortgage payment, credit cards, car loans, and even student loan debt, relative to your income.
As a rule of thumb, lenders like to see a back-end ratio of 36% or less. There is some wiggle room here, too. However, new guidelines stipulate that borrowers must have a debt-to-income ratio of less than 43% if a bank wants the ability to sell that mortgage to investors.
The math: (Annual Salary x 0.36)/12 (months) = Maximum Allowable Debt-to-Income
If your annual salary is $60,000, multiply that by 0.36 (36%), and you can afford to take on $1,800 a month in total debt.
You can also calculate your back-end ratio by adding up your total monthly debt expenses (including your estimated mortgage payment), dividing that by your gross monthly income, and multiplying it by 100.
So, if you owe $400 per month on your other debts, and your estimated mortgage payment is $1,400 per month, your total monthly debts come to $1,800. Divide that amount by your monthly salary ($5,000) and multiply it by 100. That puts your back-end ratio at 36%.
3 Critical Questions to Ask Yourself
How much you make, your creditworthiness, and how much you could reasonably borrow for a mortgage are all questions from the bank's point of view. From your point of view, consider the following.
Your timeline: It generally doesn't make economic sense to buy a home if you're only planning to stay there for a couple of years, since you'll be paying fees to buy and then sell your house.
What you can afford to put down: Ideally, you'll want to come up with at least 20% of the value of your new home as a down payment, to avoid private mortgage insurance payments (PMI).
Your comfort zone: Before you borrow $100,000, $200,000, or whatever you need for your mortgage, figure out whether you can really afford it. Just because the bank will loan it to you doesn't mean you'll be able to pay it back without sacrificing other goals.
Remember, your house payment is just one piece of your financial puzzle. Carefully consider how it fits into your overall financial and personal life.