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Buying your first home is an exciting process, but it’s not just about finding the features you want. If you’re like most people, price plays a major role in your decision. After all, even if you feel confident that you can afford a property, you’ll still have to convince a lender.
All lenders have unique lending guidelines, but they usually include some of the same key benchmarks. Here are two metrics they’ll use to decide how large a loan to issue you:
1) Your monthly housing costs as a percent of your gross income
2) Your monthly housing costs and other debt repayments as a percentage of your gross income
Two ways of looking at affordability
Conservatively, your monthly housing costs should total 28% or less of your total gross income. By this measure, a single adult with a $50,000 annual salary, or $4,167 in gross pay per month, can pay housing costs of up to $1,167 per month. This includes payments toward your mortgage principal, interest, real estate taxes and homeowners insurance.
This is a pretty straightforward method. However, most people, especially young adults looking to buy their first homes, have additional debt obligations, such as student loans, car payments and maybe credit card debt.
Because of this, lenders tend to evaluate affordability by considering your other debt repayments, in addition to your monthly housing costs and income. The preferred ratio of monthly housing costs and any other debt payments to monthly gross income is generally 36% or less.
This second metric can paint a much more accurate picture of what a first-time borrower can and cannot afford from a lender’s perspective.
Different metrics yield different results
Let’s say Jane is single and makes $50,000 annually, or roughly $4,167 in gross income per month. Her monthly debt obligations are as follows: $300 toward student loans, a $470 car payment, and a $100 credit card payment. She wants to buy a house that would cost an even $1,000 per month.
She’d qualify for a mortgage based on the first metric. Monthly housing costs of $1,000 only equals 24% of her gross income, which is lower than the 28% target.
But when Jane’s other debts are factored in, she wouldn’t qualify. Her total debt repayments equal $1,870 each month, or almost 45% of her monthly gross income. This is almost 10 percentage points higher than the suggested 36% — and it’s why lenders almost always use the second metric in conjunction the first. Together, they provide a more comprehensive view of the borrower’s situation.
Options for the prospective homebuyer
Luckily, there are several options for Jane:
• She could look for a less expensive house. If she spent $650 per month on housing costs, she’d pay 36% of her monthly gross income toward housing and other debts — equal to the preferred ratio.
• She could make a larger down payment to decrease her monthly mortgage bill, if she has enough money saved.
• She could wait to purchase a home until after she pays off her car and credit cards. This would put her mortgage and other debt at 31% of her monthly gross income.
Of course, some lenders will provide loans that are a bit outside of your budget, which is why it’s important for potential homebuyers to stay disciplined and buy only as much home as they can afford. Buying a home can be a very emotional process, especially if you’ve never done it before. By carefully thinking about your current financial situation before you start shopping, you can control some of these emotions and make the right call about the properties you view.
Now that you know two of the most popular metrics lenders use to approve loans, you can more confidently pursue your piece of the American dream with the purchase of your first home. Cheers!
Image via iStock.