How big a mortgage can you afford?

Knowing how big of a mortgage you can afford can make a huge difference down the road. It's the difference between being able to handle financial crises and potentially losing your home.

This section:

  • Describes the "debt ratio" method for analyzing affordability

  • Explains LTV and what it means for your mortgage

  • Lists additional home buying costs you should be aware of

This section lays the groundwork for an easy home loan process. In the following pages we discuss securing a mortgage pre-approval and compiling the necessary documentation for your mortgage.

In case you missed it, the first part of this mortgage planning guide covers fixing your credit, timing mortgage interest rates and managing your investment.

Debt-to-income ratios

Debt-to-income ratios are a simple (and widely-used) method for figuring how much house you can afford.

Lenders almost certainly use a similar calculation when reviewing your loan application and the ratios can also be very useful to you before you start looking for a home (or while deciding if you can truly afford one you've found.) So, how do they work?

Well, most Americans spend about a third of their incomes on housing costs, and lenders want your ratio to be in that area.

And while the one-third figure is a handy ballpark estimate, debt-to-income ratios can give you much more specific figures:

  • The front-end ratio measures how much of your gross (pre-tax) income goes toward your mortgage payments. A general rule of thumb is the front-end ratio should not exceed 28%.

  • The back-end ratio is similar, only it is a comparison of gross income to total monthly debt obligation (this includes loans, mortgages, credit card payments, child support, alimony, condominium association fees, etc). This ratio generally should not exceed 36%.

Of course, right now you may have no idea what size monthly payments you'll be facing. That's okay. The ratios can give you a good payment "ceiling" for when you do apply for a home loan. Buyers with low income or a lot of additional debt should scale back the amount they plan to spend on housing.

*And remember*, when we talk about "mortgage payments" this includes loan principal, interest, taxes, and maybe insurance. A lot of costs.

But there's another ratio to think about too . . .

The loan-to-value ratio

The loan-to-value ratio, (or more commonly, the LTV) is simply an expression of the size of your mortgage relative to the cost of your home. And the magic LTV ratio is 80%.

It's an important figure to keep in mind as you decide on a reasonable mortgage size, as home loans with an LTV over 80% often involve a higher interest rate and increased mortgage costs. By making a down payment of 20% or more, you can avoid a lot of this additional expense.

And what of these additional expenses? Exactly what costs should you expect to encounter while budgeting for your new mortgage?

The other costs of buying a home

These can take the unprepared home buyer by surprise. There are many fees, taxes, and insurance payments associated with buying a home that many first time buyers are simply not expecting.

Depending on the location of your new home,the type of lender you use, and the size of your loan, expect to pay between 3% and 5% of the mortgage amount in closing fees.

What makes up these costs? Taxes, government fees, private mortgage insurance, and lenders fees make up the majority. Include any points and the percentage goes even higher. We explain all these costs (and how to minimize them) in our guide to choosing a mortgage.

Sidebar
Our recommended prime lender, Eloan, charges no closing lender costs at all, thus saving you thousands when you buy your home. If your credit is shaky, or if you need a sub prime mortgage for any other reason, FullSpectrum Lending will approve you for a loan with the fewest fees possible for your situation.

But for now, the bottom line is . . .

How big a mortgage can you afford?

And it's a more complex question than it first appears. Depending on the particulars of your current and future financial circumstances, your credit history, the state of the housing market, and interest rate trends, your answer to this question could be very different from what you expected.

The debt-to-income and LTV ratios are good tools, but they aren't hard and fast rules.

(For example, if you live in a very high cost-of-living area or have a lot of valuable assets, you may be able to afford a larger loan than the ratios suggest.

Still, it's not a bad idea to hold yourself to these standards, even if your lender is more relaxed. Financial over extension can be very stressful and burdensome. It's really a question of honestly assessing how much you value a bigger, or better home.

And, it's is very important to take closing costs into consideration when you are deciding a reasonable price range for your new home.

Consumer advocates also recommend keeping at least a couple months worth of mortgage payments in reserve after down payment and closing costs, just in case of unexpected financial difficulties.

Next: Home buying the easy way: with a pre-approval and rate lock

Get a little financial lesson every week:

Saving on taxes is a year-long process. Start learning how to save year-round by reading our weekly personal finance newsletter, with articles, tips, blog posts, and great deals that will save you money.

Subscribe here: