Your preapproval for your mortgage just came in, and you’re excited about the budget you have to go home shopping with. However, the preapproval assumes you have a down payment, so the amount you can come up with out of pocket will definitely impact how much home you can afford.
Lenders aren’t mind readers!
Your home mortgage lender and the underwriter will be basing their evaluation of how much home you can afford on information you provide and they verify. If there is debt they don’t know about or you allocate a lot of your monthly budget to shopping or other spending, you may be biting off more than you can afford.
Be aware of things that don’t show on your credit report, like a loan you got for a family member, or a car payment you are making for a sibling. Also take into account your personal spending habits, and whether or not an expensive hobby might be taking up a significant chunk of your income.
When a lender calculates how much house you can afford, they review pertinent items such as:
- Household income
- Monthly debts
- Available cash for a down payment
- Savings in the bank or other assets
- Credit history
This information helps them calculate your debt-to-income (DTI) ratio. A “perfect” DTI ratio would show that your housing expenses (like your mortgage, insurance, and property taxes) only use up to 28% of your monthly income. If you have credit card debt, or loans for a car or education, you should still fall under 36%.
Of course, most people don’t have a DTI anywhere near that low, and that’s OK. You can still qualify for a home loan. The lender you choose and the type of loan progra you select may allow for a lower DTI.
A DTI of around 43% (or even up to 55%) can be possible if you are applying for an FHA loan. Your lender will let you know if there is wiggle room. If you are about to say goodbye to a large monthly expense, like paying off a car, they may have some discretion in approving you in spite of a current DTI. Really terrific credit or a bigger than usual down payment can also help make up for a high DTI.
A conforming loan (one that is less than the maximum amount set for federal loans) that meets the appropriate criteria from Fannie Mae or Freddie Mac may also give you some room for a higher DTI. Formerly, the ceiling was set around 45%, but there are situations that allow for a DTI as high as 50%.
A non-conforming loan, or jumbo loan (ione that is for more than the maximum allowed by a conforming loan) usually demands higher credit scores, a bigger down payment, and a lower DTI that is closer to the “ideal” 36% maximum, especially if you wnat to get the best rates available.
There is an “official DTI limit” for VA loans which is set at 41%. However, lenders can have some discretion with these types of loans, as housing for veterans is often a priority. If you have great credit or a sum large enough for a substantial down payment, more monthly debt than is ideal can be overlooked.
What’s Your REAL DTI?
Your lender will calculate your monthly income off your gross, but you may have money that comes out before the paycheck hits your bank account. If you have high withholding, and any deductions like garnishments for child support or retirement contributions, your income may take a hit.
Your lender will also look at monthly debt through the lens of reporting agencies to measure recurring monthly obligations. Of course, you have utilities to pay, groceries to buy, private school or daycare could be a costly proposition, and don’t forget about incidentals like payments for braces and sports equipment for athletes in the house.
What About Emergencies?
It can be tempting to save up three or six or even a year’s worth of wages and instantly put it down on a house, but you should have some of that money in reserve in case you are in an accident or lose your job. A new house won’t do you a lot of good if you suddenly can’t pay the mortgage every month.
Another reason not to socks all of your money into a down payment is that real estate is hard to liquidate in a crisis, and may not provide for you down the road. A smaller down payment might let you start a retirement fund, which can provide a safety net in years to come if home values fall. Think about the big picture when you ask how much house you can really afford!
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