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Life is one big balancing act of competing priorities. Just as you strive to find a balance with your time, it is also important to balance financial priorities. Buying a house is one of the largest purchases you will make, and it is one of the easiest ways to get out of financial balance. To understand your options, it is important to understand what a lender believes you can afford, but, before making your final decision, we encourage you to create your own definition of affordability.
To get an idea of the amount that a lender would be willing to extend, there are two key ratios to understand:
1. Debt-to-Income Ratio (DTI): Lenders typically require that all debt payments, including your potential mortgage payment, credit cards, car loans, child support, student loan debts and any other liability payments, be no more than 36% of your monthly gross (before-tax) income. This limit might vary from lender to lender and will likely be affected by other factors, such as your credit score and amount of your down payment. Some lenders will allow for as high as a 43% DTI ratio.
2. Housing Ratio: Specific to just the cost for housing, lenders prefer that your monthly housing payments, which include principal, interest, property tax, and insurance (PITI) and home owner association (HOA) dues (if applicable) do not surpass 28% of your monthly gross income.
Be careful before making a purchase decision based on a lender’s definition of affordability. Be sure to check it against your own. Your definition of “afford” should not be based solely on cash flow but rather in light of your other goals, both now and in the future. To help put the size of your mortgage into some personal perspective, ask yourself the following questions:
Will we be able to continue to save 20% of our after-tax income for retirement?
Related: Completing Any One of These Priorities Will Make 2018 a Financial Success
Will our expenses increase in the future and can we fully cover them (for example, children, college, and care for aging parents)?
Will we be able to comfortably spend on other financial priorities, like travel, private school, or personal care?
Despite what a lender might think, you might decide that allocating 28% of your income toward a new house is not practical. On the other hand, living in your dream home might be well worth it to you. After careful consideration, the decision is all yours!