How Much Can You Afford for a Home Loan?
As you think about applying for a home loan, you need to consider your personal finances. How much you earn versus how much you owe will likely determine how much a lender will allow you to borrow.
Estimate Your Available Finances
Income: First, determine your gross monthly income. This will include any regular and recurring income that you can document. Unfortunately, if you can't document the income or it doesn't show up on your tax return, then you can't use it to qualify for a loan. However, you can use unearned sources of income such as alimony or lottery payoffs. If you own income-producing assets such as real estate or stocks, the income from those sources can be estimated and used in this calculation. If you have questions about your specific situation, any good loan officer can review the rules with you.
Debt: Next, calculate your monthly debt load. This includes all monthly debt obligations like credit cards, installment loans, car loans, personal debts or any other ongoing monthly obligations, like alimony or child support. If it is revolving debt like a credit card, use the average monthly payment for this calculation. If it is installment debt, use the current monthly payment to calculate your debt load. And you don't have to consider a debt at all if it is scheduled to be paid off in less than six months. Add all this up to get a figure that we'll call your monthly debt service.
Housing costs: Calculate your monthly housing costs, including house payments, property taxes and insurance.
Factors Lenders Consider for Loan Qualification
In a nutshell, most lenders don't want you to take out a loan that will overload your ability to repay everybody you owe. Although every lender has slightly different formulas, here is a rough idea of how they look at the numbers.
Note that actual percentage amounts will depend on several factors such as a FICO score as well as each lenders suggested GDSR (Gross Debt Service Ratio) for the type of mortgage.
Housing costs versus gross income: Typically, your monthly housing expense, including monthly payments for taxes and insurance, should not exceed about 28 percent of your gross monthly income. This can be expressed in the formula below:
HC < or = I x .28
or, written another way
I x .28 > or = HC
where:
I = gross monthly Income
HC = monthly Housing Cost including tax and insurance
If you don't know what your tax and insurance expense will be, you can estimate that about 15 percent of your payment will go toward this expense. The remainder can be used for principal and interest repayment.
Housing and debt costs versus gross income: This is sometimes referred to as Gross Debt Service Ratio or GDSR. In addition to having housing costs be no more than a certain percent of your gross income, your proposed monthly housing expense and your total monthly debt service combined cannot exceed about 36 percent of your gross monthly income. If it does, your application may exceed the lender's underwriting guidelines and your loan may not be approved. This can be expressed in the formula below:
HC + D < or = I x .36
or, written another way
I x .36 > or = HC + D
where:
I = gross monthly Income
HC = monthly Housing Cost including tax and insurance
D = gross monthly Debt
Example Calculations
The percentage amounts used below are given for example only.Note that actual percentage amounts will depend on several factors such as a FICO score as well as each lenders suggested GDSR for the type of mortgage.
Calculating maximum monthly allowable housing cost: for a monthly income I = $4000, housing costs should not exceed $1120
I x .28 > or = HC
$4000 x .28 = $1120
Calculating maximum monthly allowable housing and debt load: for a monthly income = $4000, monthly housing costs + monthly debt load should not exceed $1440
I x .36 > or = HC + D
$4000 x .36 = $1440
Calculating maximum monthly allowable housing cost based on income and debt load: for a monthly income = $4000 and a monthly debt of $400, monthly housing costs should not exceed $1040
In the example above, we calculated above that the maximum monthly housing and debt load should not exceed $1440
now we subtract the known monthly debt
$1440- $400 = $1040
Exceptions
Depending on your personal situation, there may be more or less flexibility in the percent ratio guidelines. For example, if you are able to buy the home while borrowing less than 80 percent of the home's value by making a large cash down payment, the qualifying ratios become less critical. Likewise, if a rich relative is willing to cosign on the loan with you, lenders will be much less focused on the guidelines discussed here.
Loan Options
Remember that there are hundreds of loan programs available in today's lending market and every one of them has different guidelines. So don't be discouraged if your dream home seems out of reach. Since there are so many different lenders and loan programs, it pays to shop around.
There are a number of factors within your control which affect your monthly payment. For example, you might choose to apply for an adjustable-rate mortgage (ARM) which has a lower initial payment than a fixed-rate program. Likewise, a larger down payment will lower your projected monthly payment.