What measures determine home affordability? Mortgage lenders have traditionally expected borrowers to have a housing expense ratio of 28% or less. The housing expense ratio is an indication of a borrower's ability to make the payments on their mortgage loan. The ratio measures housing expense as a percentage of gross income (income before deducting for Social Security, Medicare, and taxes). For example, if a borrower's salary were $4,000 per month, a lender would approve their loan if the housing expense - mortgage payment, fire insurance, and property taxes - were less than $1,120 per month. $1,120/$4,000 = 0.28.
In addition to the housing expense ratio, lenders also consider a borrower's total expenses, housing expenses plus fixed monthly obligations. By traditional lending standards, total expenses could not exceed 36% of gross income. In other words, continuing the previous example, a borrower with housing expenses of $1,120 per month and fixed monthly bills of $350 would have $1,470 in total expenses per month. The total expense ratio would be 36.75% ($1,470/$4,000 = .3675), and the lender would not approve the loan.
In recent years, however, lenders have relaxed the rules, allowing many people to get approved for mortgages that they really couldn't afford. Now both the borrowers and lenders are finding themselves in financial trouble. Growing numbers of homeowners are defaulting on their mortgages and some lenders are struggling to avoid bankruptcy. As a result, lenders have become more careful about extending loans and have adopted more conservative lending standards.
Why should I analyze my budget carefully?
People typically want more house than they can afford. Perhaps it's human nature to want to stretch. In our consumer-oriented society, there are a lot of forces telling you to buy a bigger, or faster, or better thing than what you need, or started out thinking that you wanted. As tempting as it all is, you must avoid this mindset. Overspending creates financial problems that can be a source of stress and have negative effects on your marriage and family relationships. No one needs this, especially if these situations are avoidable.
The likelihood of foreclosure shouldn't be your only concern when determining how much house you can afford. Your ultimate goal is to make sure that homeownership is a joy. Establish your own spending limits that allow you to continue saving, and to continue to live a lifestyle that makes you happy. It's up to homebuyers to make sure they aren't stretching beyond what they can truly afford.
Once you establish a budget, ask yourself if you are still comfortable. If you are really comfortable with the numbers, then you might want to increase your budget a bit. However, at some point you need to draw the line and stick to it.
How do I determine my monthly housing cost limits?
Budgeting is the key to having a happy, secure financial life. Prepare a household budget and stick to what you can conveniently afford, despite the temptation to buy a bigger home or spend more money on other amenities.
These guidelines can help you to develop your own housing cost limits:
- First, calculate your provable gross income from your employment. Things such as overtime and bonuses that haven't been regular for at least two years won't be counted by a lender, but if you will continue to receive them, make a note of it for future reference as it may increase your comfort level. Consider too if a non-working spouse will be able to get a job.
- Next, calculate the total of your obligatory debt payments - car loan payments for example. If you are unclear about the exact numbers, get a credit report so you can use the same monthly payment numbers that your lender will. It's a good idea to check your credit anyway.
- Finally, examine what you are now paying for housing, either your current rent or payment on your mortgage plus taxes and insurance.
Now you can calculate your own ratios. Here's an example using simple numbers for ease of calculation:
Say your rent is $1,000 per month and your gross income is $3,300 per month. Your housing expense ratio is $1,000/$3,000 = 33%.
Next add your other expenses, say $300 per month. The total expense then is $1,300 and your total expense ratio is $1,300/$3,000 = 43%.
A lender would say that your ratios are "33 over 43." Note that these ratios are higher than traditional 28 over 36, but your mortgage might still get approved today.
Now think about how comfortable you are at this level. Perhaps you are single or have no kids and you are able to save money every month. There's still some room in the budget even though the ratios are a little high. Other borrowers with the same numbers but with two children might feel terribly stressed on this budget.