When it comes to closing on a new home purchase, few things can expedite the process more than getting preapproved for a mortgage. And in housing markets where buying competition leads to quick closings, preapproval is crucial and ensures that sellers take your offer seriously.
Seeking preapproval is a smart move, but it pays to understand the difference between how much house you can afford and how much lenders are willing to let you borrow. The two rarely align.
That's why Motley Fool analysts Kristine Harjes and Nathan Hamilton discuss in the following video the debt-to-income ratio and how banks use it to size up homebuyers for a new mortgage. Understanding these factors could help you crush budgeting goals, so tune in to ensure you're on the right path.
Kristine Harjes: When you're in the market for a mortgage, one important step that many people take is getting preapproved. Something that comes out of that preapproval is a number. The bank says, "Hey, this is your preapproval number. You're preapproved to borrow this much. Should you believe that number?
Nathan Hamilton: We would say at The Motley Fool generally not, because if you look at the official formulas, a bank will lend you up to 43% debt to income, and that specifically is your monthly debt payments divided by your gross income. And gross income is essentially that very top line on your paycheck before tax. And that's what a mortgage lender will provider to you for a mortgage.
Now, if you look at the economics of your financial situation, 43% is actually a very high amount, because when you buy a new home, there are different expenses. You've got HOA fees. You've got utilities, and on average new home buyers spend about $13,000 on renovations -- furniture; knocking out that wall to make the kitchen perfect. Those are actual costs that you need to take into account.
Forty-three percent is just a very high number. Getting below 40% is better. I would actually suggest even going lower than that to have a rainy-day fund. To have money to invest in your future. To have money for the renovations. To have money for whatever life throws at you, you really need to be below 35%.
Harjes: Right. An important component of that is that it is gross income, so you're not even thinking about the fact that you might have taxes taking away a quarter of your income, so you need to have that rainy-day fund. You need enough to cover not just your taxes and the mortgage payment, but as you mentioned, all the expenses that add up when you go to buy a home.
Hamilton: And if you look at it, just throwing some numbers behind it, the average U.S. household's salary income is just above $50,000, and a lender would say, "You could afford about $1,791 per month." That's about a $380,000 mortgage with no down payment. We're not accounting for that.
We say below 35%, actually keep it at $1,458. You don't have to be exactly at that amount, but that essential equates to a $315,000 mortgage.
KRISTINE HARJES: Which is a pretty significant difference -- a $380,000 mortgage versus $315,000. Here at The Motley Fool we do believe in investing smartly and being conservative with your money, so keep that 35% in mind when you're shopping around.
If you're looking for more information about mortgages, you can go do fool.com/mortgages, where you can calculate how much house you can afford. Or even download our free mortgage guide, "5 Tips to Increase Your Credit Score Over 800."