By Lisa Smith
"How much house can I afford?" It's a critical question that every homebuyer faces, and one that many people answer by going to a lender and taking out the largest mortgage that the lender will approve. While this strategy will help you get the largest, most expensive house that you can qualify for, being eligible for a loan and being able to afford the property aren't necessarily the same thing. (For more insight, see Mortgages: How Much Can You Afford?)
From a lender's perspective, loan eligibility is based on a formula. The most common rule of thumb is that your monthly mortgage payment should not exceed 28% of your gross income. This calculation includes more than just the base price of the house. Consider, for example, a $50,000 gross income. Based on 28% of that amount, the mortgage payment would be $14,000 per year or $1,166.66 per month. That $1,166.66 needs to cover all four potential components of a mortgage: principal, interest, taxes and insurance, often referred to as PITI.
If your credit history is good, the lender may let you take out a mortgage with a monthly payment equal to 30% or even 40% of your gross monthly income. In our example, 40% would get you a yearly mortgage payment of $20,000 or $1,666.66 per month. The $500 per month difference would let you afford a more expensive home, but you should take a close look at your finances before making such a decision.
Gross Vs. Net Income
Although mortgage eligibility is based on gross income, your monthly payments are made from your net income. This means that your ability to afford the payments can look quite different once the mortgage actually needs to be paid. That $50,000 gross income is reduced to $36,000 net after 28% goes to pay taxes. Taking $20,000 out of that to pay the mortgage leaves you $16,000 to live on for the year. On a monthly basis, that's $1,333.33. Factor in a car payment, credit cards and student loans to cover the cost of your education or tuition bills for your children and there might not be much left over at the end of the month. Although you may be able to qualify for that $1,666.66 loan on paper, actually taking it might not be the best financial move that you could make. On the other hand, if you are debt free and have a rainy-day fund stashed away in case of emergencies, a mortgage that takes up such a large chunk of your gross income may not be a problem. (For more insight, read Are You Living Too Close To The Edge?)
Another rule of thumb to consider is that your debt-to-income ratio should not exceed 36% of your gross income. To calculate your maximum monthly debt based on this ratio, multiply your gross income by 0.36 and divide by 12. For example, if you earn $50,000 per year, your maximum monthly debt expenses should not exceed $1,500, which would include your mortgage. Referring back to our example, the $1,333.33 monthly mortgage payment might be enough to break the bank for someone with heavy debts or big spending habits, while the $1,666.66 monthly payment is just slightly more than the 36% of gross income and perhaps well within the means of a prudent spender.
Sitting down with a calculator will give you a good idea of where you stand in relationship to the loan amount you can probably qualify for and the debt-to-income ratio that you can actually afford. In the excitement to purchase a new home, don't lose sight of the reality that lenders are in business to make loans. They will let you borrow the maximum amount that you can qualify for because they charge interest on that amount. The more money you borrow, the more money the lender earns in interest. Also, many lenders sell their loans to investors, so the lender itself many not stand to lose anything at all if you default on your loan.
Taking out a large loan often results in a situation referred to as being "house poor". Being house poor is generally not a good idea. While you may be able to make the monthly mortgage payments and even pay your other bills too, you are one large expense away from disaster. Should you need to make a major repair to your car, purchase a new appliance, or encounter any other scenario that requires a substantial outlay of cash, you are going find yourself in a tough spot and could end up losing your home, filing bankruptcy, or both.
Play It Safe
Regardless of the size of the loan a lender offers, don't buy more house than you can afford. If you purchase a home and, after making the payments for a few years, find that you have considerable discretionary income left or have substantially increased your income since making the purchase, you can always move. Of course, if you like where you live, you can make extra payments and potentially retire your mortgage early.
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