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By Lois Sullivan
Once you decide to travel the path toward home ownership, you might ask yourself, "How much mortgage can I afford?" It’s an important question because missing your mortgage payments can have serious consequences. A single missed payment typically results in a late fee and a hit to your credit score. With consecutive non-payments, your lender may begin the foreclosure process. Planning and preparation are key to avoiding such a financial mess. Here is a guide on the nuances of home loans and how to calculate your budget.
The first step to assessing how much mortgage you can afford is understanding your current financial health by determining your available budget.
That begins with calculating your monthly net income, the total amount of money you bring in after taxes and deductions. For every source of household income, review the past year’s pay statements and average them out by month. If the monthly pay fluctuates, add up all your household's deposits and then divide the sum by 12.
Next, calculate your monthly expenses. First, write out a comprehensive list of every fixed cost, such as your rent, utilities, car payment and subscriptions. Then, estimate your variable costs, such as groceries, clothing, haircuts and entertainment. Add these figures together and subtract the sum from your monthly net income. The remainder is how much you have left for a mortgage.
Bear in mind the importance of having a realistic understanding of your financial picture, as spending your entire remainder on a mortgage payment every month wouldn’t be prudent. The current rule of thumb is you shouldn't spend more than 28% of your monthly income on the mortgage, so calculate that percentage of your monthly earnings and set aside what remains for added security. Another good idea is to save up at least six months’ worth of income so you have a cash reserve to lean on in case of financial disruptions or emergencies.
Debt-to-income ratio is a metric that describes what percentage of your income goes toward debt payments. Here, “debt” refers to practically any monthly recurring expense — not just loan repayments but also rent, credit card bills, and child support (utilities, groceries, gasoline, and taxes typically don't count toward your debt). A home lender will use this metric to assess your ability to satisfy your mortgage obligation.
Calculating your debt-to-income ratio involves adding up all your monthly debts and dividing them by your gross monthly income, or the amount you earn before taxes and deductions. Say that you earn $5,000 per month gross and have debts of $150 for your car loan, $200 for your student loans, and roughly $1,000 minimum payment for credit cards. The sum of your monthly debts would be $1,350, which, divided by $5,000, amounts to a debt-to-income ratio of 27%.
When it comes to mortgages, the highest debt-to-income ratio that many lenders are willing to tolerate is 43%. However, most lenders prefer a lower ratio of below 36%.
The more money you put down on your home purchase, the less likely you will owe on your monthly mortgage payment. The reason isn’t only that you’d be borrowing less money but also that lenders tend to offer lower mortgage rates in return for higher down payments.
You’ll need to put down at least 3% of the home’s total value to qualify for most mortgages. Other common down payment percentages are 5%, 10% and 20%. Please note that your credit profile may influence the minimum amount you need to pay upfront to qualify for a mortgage. For borrowers with poor to fair credit scores, lenders generally require a minimum payment of 10% to minimize their risk.
If you need some help saving up for a suitable down payment, consider these tips:
Every mortgage payment covers both the principal and the interest, so the interest rate your lender offers will significantly impact how much you owe monthly. One key factor that influences the interest rate you receive is the loan term, meaning the length of your mortgage.
The two most common loan terms are 15 years and 30 years, and each comes with its own set of pros and cons:
Having a higher credit score and comparing offers from multiple lenders can help you lock in a more favorable rate.
The simplest solution to determining how much mortgage you can afford is to use a mortgage affordability calculator. To use one, all you must do is input data such as your income, debt value, your maximum down payment, and possibly the location of your housing market. The calculator will then do the math for you and present you with a monthly mortgage estimate.
If you’d like to learn more about taking out a mortgage and how much you can afford, we welcome you to get in touch with us by contacting an Alliant Credit Union mortgage loan officer. We offer a variety of home loans and would be happy to speak with you about your options.
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