What do your debt-to-income (DTI) ratio, mortgage pre-qualification approval amount, and your gross household income all have in common? Surprisingly little, if aiming to make a financially sound decision when buying your first home. Not one of these figures can answer the ultimate question of home affordability. However, some real estate professionals would have you believe that your mortgage pre-approval amount should be the guiding factor in determining how much to spend on your first home.
In reality, you may pre-qualify for more home than you can actually afford. How is this possible? Mortgage lenders use your DTI, along with other factors, to determine the maximum mortgage loan for which you’re eligible. This is figured by comparing monthly debt payments to your gross monthly household income.
The standard recommendation is to stay below a DTI threshold of 36 percent to qualify for a mortgage, although the exact percentage may vary by lender. The ratio is a snapshot of your financial stability, which can change over time. Borrowers can lower their DTI by increasing their income or reducing their debt obligations.
While your DTI is an indication of your debt load, it doesn’t consider how you spend your net income. For example, retirement contributions, utility payments, groceries, and other voluntary expenses vary by household and are not considered in the DTI calculation. Borrowers shouldn’t rely solely on their mortgage pre-approval amount to determine home affordability.
By figuring exactly how much net income you have available each month, identifying pre-closing and post-closing costs and acknowledging your other financial goals, you can definitively answer one of the most common home buying questions, “How much home can I afford?”.
Here are several factors that can help you narrow down a price range for your new home.
Net Household Income
Your net household income, aka “take-home pay,” is the amount of money in your paycheck after the removal of federal and state taxes, health insurance premiums, and retirement contributions. The remaining amount is income you can spend as you wish, including living expenses and saving for short and long-term financial goals.
A standard recommendation is to limit your housing expense to 25 percent of your net income. Housing expenses include the mortgage principal, interest, property taxes, and insurance (PITI) along with homeowner or condominium association fees. As you review your financial situation, you may find that even this figure is too high. Examine your budget to determine how earmarking 25 percent for housing expenses would impact your other financial obligations and spending habits.
Down Payment, Closing Costs, and Other Expenses
Buyers who deplete their savings to cover the down payment and closing costs may be in for an unwelcome surprise. The costs of owning a home extend beyond the monthly mortgage payments. Home maintenance, repairs, and emergencies are inevitable, even with new construction homes. Purchasing a home for a price that leaves breathing room in your budget can help avoid unnecessary financial stress. Make sure you have sufficient funds left in your budget each month to build an emergency fund and pay for routine maintenance. If possible, set aside at least three months of living expenses in an emergency fund account before purchasing a home.
Other Financial Goals
Buying a home for more than you can afford can leave you “house poor.” This term is often used to describe homeowners with little money left over after paying their mortgage each month. Planning and saving for retirement, college, or vacations becomes difficult when little is left over each month. Your monthly budget is key to determining home affordability. Without breathing room in your budget, you’ll have a tough time if you have a financial emergency or intend to meet your other financial goals while owning a home.
Use your budget to perform some easy math, and you’ll know how much home you can comfortably afford. Be realistic while considering your options. Securing a mortgage at an amount that leaves plenty of wiggle room in your budget is fiscally smart. You’ll have funds available to meet your other financial goals and enjoy your preferred lifestyle. Your ideal home could turn problematic if you find you can’t afford the payments after the first year. Now that you know how much house you can afford, why not get prequalified for a Generations mortgage?
Written by Freelance Personal Finance Writer, Tracy Scott