What do lenders look at?
When you’re buying a home, mortgage lenders don’t look just at your income, assets, and the down payment you have. They look at all of your liabilities and obligations as well, including auto loans, credit card debt, child support, potential property taxes and insurance, and your overall credit rating.
How do you determine the price you can afford?
When determining what home price you can afford, a guideline that’s useful to follow is the 36% rule. Your total monthly debt payments (student loans, credit card, car note, and more), as well as your projected mortgage, homeowners insurance, and property taxes, should never add up to more than 36% of your gross income (i.e. your pre-tax income).
While buying a new home is exciting, it should also provide you with a sense of stability and financial security. You don’t want to find yourself living month to month with barely enough income to meet all your obligations: mortgage payments, utilities, groceries, debt payments – you name it.
Using the 36% Rule
In order to avoid the scenario of buying a house you truly can’t afford, you’ll need to figure out a housing budget that makes sense for you. That means that for every pre-tax dollar you earn each month, you should dedicate no more than 36 cents to paying off your mortgage, student loans, credit card debt, and so on. (Side note: Since property tax and insurance payments are required to keep your house in good standing, those are both considered debt payments in this context.) This percentage is also known as your debt-to-income ratio or DTI. You can find yours by dividing your total monthly debt by your monthly pre-tax income.
What if you have a higher debt-to-income ratio?
Most banks don’t like to make loans to borrowers with higher than a 43% debt-to-income ratio. Although it’s possible to find lenders willing to do so (but often at higher interest rates), the thinking behind the rule is instructive.
If you are spending 40% or more of your pre-tax income on pre-existing obligations, a relatively minor shift in your income or expenses could wreak havoc on your budget.
Banks don’t like to lend to borrowers who have a low margin of error. That’s why your pre-existing debt will affect how much home you qualify for when it comes to securing a mortgage.
It is also in your best interest to keep this rule in mind.
Since lenders tend to charge higher interest rates to borrowers who break the 36% rule, you’ll probably end up spending more on interest if you go for a house that places you beyond that limit. Plus, you may have trouble maintaining your other financial obligations, including building up your emergency fund and saving for retirement.