How Much Home Can You Really Afford?
Most people take for granted how much home they can afford. If the real estate agent or mortgage professional tells you that you can get up to a $300,000 home, do you argue? Probably not. Most people don't question it. But you should understand it and make sure you don't get in over your head in mortgage payments.
How do mortgage professionals decide how much home a person qualifies for? There are several factors: credit score, total assets and what's known as your "debt-to-income" ratio (DTI). Your DTI is extremely important, yet most people have never heard of it. In simple terms, DTI is your total "minimum" monthly debt payments divided by your gross monthly income. Here's a good rule of thumb: the lower your DTI, the better.
What is "minimum monthly debt?" It's the amount you are required to pay on a monthly basis, like your car payment, student loans and credit card payments. If you pay more than the minimum amount on your credit cards, this does not count against your DTI, since only the minimum amount you're required to pay is included in the total.
Here's a quick example:
Your gross monthly income is $1,000. You also have a car payment of $250, and a credit card that requires a minimum payment of $50. Your minimum monthly debt is $300. You divide 300 by 1000 and your DTI is 0.3. Since DTI is normally referred to in percentages, that 0.3 becomes 30 percent.
Any DTI less than 50 percent is considered workable by most mortgage professionals. If the DTI is higher than 50 percent, it can be difficult to qualify for a mortgage. The lower your DTI, the more you can borrow and the more options you'll have. A DTI of 20 percent or below is considered fantastic.
Keep in mind that minimum monthly debt simply means the minimum you have to pay each month. Even if you owe $5,000 on a high interest credit card, if your minimum monthly payment on that card is $100, that is what goes into figuring your DTI. But be careful. Only paying minimums can actually make some debts grow larger.
Other Home Owner Expenses
Another factor to understand with DTI is that only debt reported on your credit report is included. Other monthly expenses are not. So, for example, some utilities may not be included. Certainly your telephone isn't. Your property taxes aren't. These are considered "housing expenses." Monthly food expenses, then, by the same logic, aren't included either.
The point is that there are many expenses above what is used to figure your DTI, so plan well when purchasing a home. You don't want your expenses to overwhelm you once you settle in your new home. You might end up not being able to afford your mortgage after all, which is a losing situation for everyone -- you, the mortgage company and the economy.
Go over all your expenses and debts with your mortgage professional when buying a home. Make sure you understand how your home affordability is calculated. By planning properly, you'll be in the best financial shape to make sure your dream home doesn't turn into a nightmare.
- Last edited October 12 2012
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