How big is “too big” when you’re thinking price tag on a new house?
That’s the question that’s on everyone’s mind when they first go new-home shopping: What size mortgage can I afford?
It’s a prudent thing to ask and sensible when it comes to your finances. Part of the whole Great Recession in 2009 was an issue with home buyers taking on far too high of a mortgage value than they could afford. (That and getting themselves into mortgage products that were probably not the most ideal for their situation).
So to avoid another house buying implosion, a smart consumer will first take a look at their financial situation in the mirror and see what makes the most sense for their situation. Here’s a few tips to help you decide how much debt you can afford to take on.
What Size Mortgage Can I Afford? The General Rule of Thumb:
In the absence of all other information, one general rule of thumb you could use to gage how much house you can afford is to multiply your gross household income by 2 or 2.5.
For example: If the two of you make $200,000 combined before taxes, then you should be able to afford a mortgage that costs somewhere between $400,000 and $450,000.
While that’s a pretty simple guideline to follow, many other variables will of course dictate whether or not you’ll actually qualify for a mortgage. They are the front-end and back-end ratios.
The front end ratio is used to look at how much mortgage you can afford based on your gross income.
What you do is to add up your total monthly mortgage payment, which includes the principal, interest, and escrow (PMI, insurance, and taxes).
Now compare that number to your monthly combined household income. Most financial planners agree that this ratio should not exceed 28%, although lower is safer.
By following that advice, if your income is $5,000 per month, then your total mortgage payment should not exceed $1,400 per month.
The place where some people run into trouble is when mortgage providers will still give you the loan even though you’re at 30% or even 40%. Remember to keep your best interests ahead of what a loan provider is or is not willing to offer you.
Another factor mortgage lenders take a hard look at is something called the back-end ratio or debt-to-income ratio.
This ratio compares all your debts (your mortgage, credit card payments, child support, other loans, etc.) and then again compares them to your gross income.
Your debt-to-income ratio should not go beyond 36%. Again, if you assume a monthly income of $5,000, that means you shouldn’t have more than $1,800 each month of debt payments.
Just like with the front-end ratio, you have to watch out for yourself. Some lenders will still approve you for the loan even if your back-end ratio is as high as 45%. You have to know for yourself what you can afford.
Other Mortgage Size Variables to Consider:
There are lots of other things that could make or break how much house you can afford.
The down payment for example is one of the biggest factors. Most home lenders want you to put down at least 20% (even though a lot of them are willing to work with less).
Suppose you have a lot of money saved up for a home down payment. In that case you could afford to buy more house than someone with less start up money.
Another thing that makes a big difference is the mortgage interest rate. The mortgage interest rate can have a significant bearing on the magnitude of the overall monthly mortgage cost. In general, the lower the rate the better; although remember that not all mortgage products are the same and some might have interest rates that fluctuate. Use a helpful online home loan comparison site to see what mortgage rates and deals are available.
The final thing that should be considered when you’re asking yourself what size mortgage can I afford is to consider your lifestyle.
- Are you fugal?
- Do you have a lot of other expenses?
- Do you live in a high-cost area?
- Are you going to use part of the house for rental?
- Would you rather invest the money?
There are dozens of questions pertaining to your unique lifestyle that will actually determine how much home you can comfortably afford. Make a list of your priorities and see where the size (and cost) of your perspective house falls in line with them.
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Before even starting the process, talk with a professional financial adviser and real estate agent to get a good idea on the price range you are able to afford. It will help make your search much easier.