Understanding Mortgages and Debt-to-Income Ratios for Homebuyers
Do you know how much house you can afford? Many first-time home buyers, in their excitement, begin looking at every house that catches their fancy—only to be disappointed when they find out the monthly mortgage payment is double their monthly income. A mortgage is a loan secured by the home, but when lending such a large amount of money, most banks or lenders will have requirements to qualify. Understanding how these requirements affect your ability to borrow will help you determine your price range when house shopping.
How Your Debt-to-Income Ratio Affects Your Mortgage
Anytime you borrow, a lender will want to know whether or not you can make the monthly payment on the loan. To assess how much you are capable of paying each month on a mortgage, a bank will calculate your debt-to-income (DTI) ratio. In its simplest terms, a debt-to-income ratio is the percentage of your monthly gross income that goes towards monthly debt payments such as student loans, car loans, and credit cards. However, when you begin a mortgage loan application with a lender they will commonly calculate two different debt-to-income ratios: the housing expense, or front-end, ratio; and the total debt-to-income, or back-end, ratio.
The Front-End Ratio
The housing expense ratio shows what percentage of your annual pre-tax income would go towards housing. For instance, someone who makes $2,400 per month and spends $600 per month on their mortgage and all other home expenses would have a front-end ratio of 0.25. Lenders don't want your front-end ratio to be any higher than 0.28, so to calculate the absolute most house you could afford in a hypothetical debt-free scenario, multiply your annual salary by 0.28 and divide by 12. Voila! You now know the most you can spend per month on a mortgage.
The Back-End Ratio
The back-end ratio is a calculation of your total debt-to-income including mortgage, car loans, student loans and any other monthly obligations. If the same person from the previous example had $600 in credit card payments and other monthly debt in addition to their $600 per month mortgage they would have a 0.5 total DTI. Banks prefer a ratio no greater than 0.36, so to determine how much per month you can spend on housing and all other debt multiply your gross income by 0.36 and divide by 12. In our hypothetical case the calculator yields $864, which means that to afford $600 of housing realistically, all other debt would need to amount to no more than $264.
Insurance, Taxes and Other Hidden Expenses
Note that when we calculated the front-end ratio we mentioned "all other home expenses." When you purchase a home you will have to pay annual property taxes, and most mortgage lenders require mortgage insurance for the duration of the loan. Both taxes and insurance payments are included with the mortgage payment itself to arrive at the total housing expenses, which in our example was $600. Realistically you should also budget for maintenance and repair, which will add even more to your total housing cost.
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