Homeownership has long been the American Dream, and the housing boom at the turn of the century gave many individuals what seemed like the perfect opportunity to make that dream a reality. Unfortunately, a combination of exotic mortgage products and an unprepared public led to the largest housing crisis in decades. The first steps in avoiding a repeat of this awful period in our history is for prospective homebuyers to understand exactly how much house they can afford, and how much it will take to maintain ownership in the years that follow.
First, it’s important to develop a realistic understanding of how much of a mortgage you will qualify for. This is dependent on two specific ratios that we’ll discuss in a few moments. Second, and perhaps more important, you have to determine just how much of a home you really need. Lenders will qualify you based on current underwriting procedures, not necessarily on what you can afford. The burden falls on you to understand exactly the size of the mortgage payment you can make month after month, year after year. For instance, when determining affordability, lenders typically base their calculations on your gross monthly income. As you know, your gross income represents earnings before taxes and other deductions are taken out. For example, if you were to earn $50,000 a year, your gross income each month would be around $4,100. However, depending upon your tax bracket, your net income can be very different. In this scenario, your tax obligation would be approximately $8,600 annually, which would make your monthly net income $3,376. That’s a big difference.
Furthermore, there are other aspects of affordability that your lender probably won’t take into consideration. Do you pay for childcare? Do you pay child support? If you have any obligations that aren’t considered debts, yet you have to pay them each month, this can dramatically change your ability to maintain a mortgage payment. Therefore, creating a realistic budget is the very first step in understanding what you can afford. When determining affordability, it is highly recommended that you contact a HUD- approved housing counseling agency, such as Cambridge Credit Counseling Corp., to participate in pre-purchase counseling. Not only will this help you figure out what you can afford, but your counselor will also discuss other expenses that you’re likely to incur, further challenging your ability to maintain your mortgage payment.
So, how do lenders determine how much of a mortgage payment you can bear? There are two commonly used calculations. The first is a borrower’s housing ratio, which is the percentage of your gross monthly income that can be used to make monthly house payments. This would include principal, interest, taxes and insurance. Our previous example featured a gross monthly income of $4100, so let’s base our calculation on that. In that situation you would t see the ake the gros your you an e-mail in an agency’s is s monthly income and multiply it by the recommended 28% of income that should be used for such an expense. Different loan programs may allow for different housing ratios; however, we’ll focus on the more traditional approach. So, we take our $4100, multiply it by 28%, and we come up with $1,148 – the monthly mortgage payment the lender believes you can sustain.
Lenders also take a second look by adding into their equation any other household debt that exists, including credit card debt, car loans, college loans, and so on. After the debt is added, the optimal debt-to-income ratio for sustainability is 36%. Again, there are different loan programs that can accommodate higher ratios, but we’re focusing on broadly accepted practices. Okay, now we take the gross monthly income, $4100, multiply it by 36%, and come up with $1476. This amount would be the maximum recommended amount of all debt payments, including your mortgage payment.
In some instances, these numbers may indicate that an individual is mortgage ready, and on their way to homeownership. However, these numbers can also indicate that you might not be ready to own a home — just yet. In many cases, although the bank believes you can sustain a payment, your instinct may tell you this is not necessarily the case. Therefore, it’s important for you to establish a workable budget, a realistic plan for homeownership, and take some time to speak with a housing counselor to make sure you’re on the right path.