There are two basic formulas commonly used by lenders to determine how much of a mortgage you can reasonably afford. These formulas are called qualifying ratios because they estimate the amount of money you should spend on mortgage loan payments in relation to your income and other expenses.
It is important to remember that the following ratios may vary from mortgage lender to lender and each application is handled on an individual basis, so the guidelines are just that -- guidelines. There are many affordability programs, both government and conventional, that have more lenient requirements for low- and moderate-income families. Many of these programs involve financial counseling to help potential home buyers learn about the financial responsibilities of owning a home.
Generally speaking, to qualify for conventional mortgage loans, housing expenses should not exceed 26% to 28% of your gross monthly income. For FHA mortgage loans, the ratio is 29% of gross monthly income. Monthly housing costs include the mortgage principal, interest, taxes and insurance, often abbreviated PITI. For example, if your annual income is $30,000, your gross monthly income is $2,500, and $2500 x 28% = $700. So you would probably qualify for a conventional home loan that requires monthly payments of $700 or less.
Any expenses that extend 11 months or more into the future are termed long-term debt, such as a car loan. Total monthly costs, including all long-term debt, should equal no greater than 33% to 36% of your gross monthly income for conventional loans. Using the same example, $2,500 x 36% = $900. So the total of your monthly housing expenses plus any long-term debts each month cannot exceed $900. For FHA the ratio is 41%.
When budgeting to buy a home, it is important to allow enough money for additional expenses, such as maintenance and insurance costs. If you are purchasing an existing home, gather information such as utility cost averages and maintenance costs from previous owners or tenants to help you better prepare for homeownership.
Homeowner's insurance or property insurance is another cost you will have to consider. The lending institution holding the mortgage will require insurance in an amount sufficient to cover the loan. To protect the full value of your investment, you might want to consider purchasing insurance that provides the full replacement cost if the home is destroyed. Some insurance only provides a fixed dollar amount which may be insufficient to rebuild a badly damaged house.
Loan-to-value (LTV) ratio determines size of the loan.
The LTV ratio is the amount of money you borrow compared with the price or appraised value of the home you are purchasing. Each loan has a specific LTV limit. For example: with a 95% LTV loan on a home priced at $50,000, you could borrow up to $47,500 (95% of $50,000), and would have to pay $2,500 as a down payment. The LTV ratio reflects the amount of equity borrowers have in their homes. The higher the LTV ratio, the less cash homebuyers are required to pay out of their own funds. So, to protect lenders against potential loss in case of default, higher LTV loans (80% or more) usually require a mortgage insurance policy.