Buyers Can Prevent Future Problems With This Financial Formula
The place to start when you’ve decided you want to buy a home is to understand all of the financial components involved. A buyer’s financial situation can make a big impact on their ability to qualify for and obtain a mortgage. The first step when analyzing for financial situation is to look at the amount of money you make compared to the amount of debt you have. Here we break down why this debt to income ratio matters, how it affects your ability to get a mortgage, as well as the role it plays in making monthly payments and being a homeowner.
What Is A Debt-to-Income Ratio & Why Does It Matter?
A debt to income ratio is fairly self-explanatory. It’s the difference between the amount of money you’re bringing in (the income) to the amount of money that’s going out (your debts).
The reason it matters is for buying a home is because buyers have to have a specific debt-to-income ratio to qualify for a loan with a mortgage company.
When thinking about a mortgage, 43% is the magic number to keep in mind.
Many mortgage companies (though, of course, there are exceptions) will only approve a loan if a buyer’s monthly debt payments are at or under 43% of his or her take-home pay. It’s important to note that 43% is at the top of what a mortgage lender will approve, so having it lower than this is ideal.
Let’s Break This Down:
Say a buyer’s take-home pay is $6000 per month and these are the monthly payments he or she makes:
Based on this, their current debt payments are only 22% of the potential buyer’s take home pay. From these numbers alone, the data seems to position them well for a mortgage approval.
If you want to try your hand at your own debt-to-income analysis, NerdWallet has an easy to use calculator that does the work for you.
Why You Shouldn’t Rely On The Debt-to-Income Ratio Alone
As we saw above, it can appear on paper that someone could be easily approved for a mortgage. However, even if a lender might approve you, you want to make sure your mortgage payment isn’t more than you can comfortably afford.
While your debt-to-income ratio might be within the right range, you should remember that the lender hasn’t accounted for all of your other bills.
Consider how much you spend on gas, groceries, childcare, entertainment, etc., and then figure out how much you can really afford when it comes to a mortgage payment.
Let’s Break This Down:
For example, your regularly occurring expenses might look a little something like this:
Adding together recurring expenses at $1900 a month with recurring debts at $1300 a month, you reach a total of $3200. With $6000 in take home pay, that means your expenses and debt are already consuming over 50% of the total.
Especially if you want to put money into savings, deal with emergency situations that may crop up, have money to handle the costs of homeownership, etc, you’ll want your mortgage to be no more than 30% of your total income.
Only you know what your current budget looks like outside of the amount of debt you carry.
If you want some help on how best to budget when you’re thinking of buying a home, Dave Ramsey, Investopedia, and Mint all have great budgeting tools and ideas tailored to making this process easier.
Remember as you move forward in the home-buying process what it is that you can truly afford each month. Even though you might be offered a loan that after banks review your debt-to-income ratio, that doesn’t mean you need to spend the full amount you’re approved for. Make sure you to come up with an idea of the amount ahead of time that you can comfortably afford each month. This will help you to stay within your budget and not overspend when you take the next steps to home ownership.