Image courtesy of Flickr, 401(K) 2012
Learn how to calculate how much house you can afford and determine your monthly payment and mortgage loan amount.
If you're asking yourself this question before you buy a new house you're already ahead of the curve. By figuring out how much of a house you can afford you ensure that you don't over extend your ability to make the payments. Additionally, you'll save time by only looking at homes within your affordable range.
Based on your own unique scenario, what you can afford may be less or more. The rest of this post will show you how. Or, you can use this handy Mortgage Affordability Calculator.
While you may have a gut feeling about how much you can afford each month, mortgage lenders have a specific method to calculate how much they're willing to lend you. So, to answer this question you'll have to look at it from a lenders perspective.
First, you'll need to determine how much of a mortgage you can afford each month, then knowing that number, you can determine the loan amount you'll be able to afford and voila, you'll know how much of house you can afford.
Here's how to do this:
The first thing to do is determine how much of a maximum debt payment you can afford based on what your income is. To do this, you'll need to know your gross income and then take into consideration the lender's DTI requirements.
Your gross income is how much you make before paying taxes and other deductions such as retirement contributions and health insurance.
DTI is your debt-to-income ratio. Every lender has different DTI requirements, but generally speaking, the most common DTI is 36%.
|Your monthly gross income:||$6,000|
|Lender's maximum DTI limit:||36%|
|Multiply gross income by DTI:||
|Your maximum debt payment:||$2,160|
Based on the calculation above you can afford a maximum of $2,160 towards your debt payments each month. It's important to note that your debt payment includes not only your principal, interest, property taxes and insurance (PITI), but also your revolving debt payments as well.
In other words, what you pay towards PITI and other debt payments must not exceed $2,160.
PITI represents your total housing cost that you make each month. PITI tells your lender how much of your monthly income is used to keep the house.
To calculate your PITI you need to back out other debt payments you're required to make each month from your maximum debt payment that we calculated earlier.
Other debt payments include your car payment, credit card payment, student loan payment, alimony/child support and other similar debt commitments. Do not include monthly payments such as cell phone bills, childcare and auto insurance.
Here's how to calculate your PITI:
|Your maximum debt payment:||$2,160|
Determine total monthly debt payments:
a) Car payment
b) Personal loan payment
c) Student loan payment
|Subtract debt payments from maximum debt payment:||
|Your maximum PITI payment:||$1,810|
Now that you know your PITI payment you can calculate how much of a house you can afford by determining how much of a mortgage loan amount you can afford.
Unfortunately, determining your loan amount requires some complicated math beyond the scope of this post. However, here's an easy House Affordability Calculator that'll do the math for you.
If you care to know, here's how the house affordability calculator works:
Once you know your maximum PITI, you'll need to accurately determine your principal, interest, taxes and insurance. To do this you'll need to know the loan terms that you're being offered, such as your interest rate and how many years your loan will be for.
Next, you'll need to determine your insurance and property tax. Your insurance is easy as getting a quote from a mortgage insurance company and dividing that number by 12 months. However, your property tax is really tricky to figure out since property taxes are a percentage of the value of the home you're buying, but you don't know how much of a house you can afford yet!
With the help from math wizard Hugh Chou we use a technique called iteration which essentially means that we guess how much of a home you can afford, and then we keep on guessing until we converge onto a number that makes all the math work.
If you make $6,000 in gross income per month at a 36% DTI ratio, your maximum affordable debt payment is $2,160. Then, backing out $350 in other debt payments you maximum PITI payment is $1,810. Based on 30 year fixed mortgage at 4.5% with 1.1% in property taxes, you'll be able to afford a mortgage loan amount of $302,498.
Understanding how much house you can afford is the responsible thing to do. Knowing you'll be able to afford your monthly mortgage ensures you'll only get a mortgage which you have high confidence that you'll be able to afford.
Having that peace of mind makes buying your first home or upgrading into a new home a pleasant and exciting experience.
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