How much home can you afford?
This is fundamental question that every buyer should be asking prior to starting their home search. Most people have a really good idea of how much of a payment they can afford, but few know exactly how much of a loan they will qualify for.You see, there is a difference between what you can afford and what you will likely qualify for. When a buyer thinks about how much he or she can afford monthly towards mortgage payment, more often than not they focus on the best case scenario. The bank on the other hand looks at the opposite when they try and qualify you. Let me explain how a bank qualifies a prospective home buyer.
Lenders follow two simple rules to determine how much you can afford and they will use the same criteria with a pre-approved mortgage as with the actual financing application.
These two rules are your Gross Debt Service (GDS) ratio and your Total Debt Service ratio (TDS). A lender may consider just the TDS or both the TDS and the GDS to determine if a buyer qualifies for a loan.
Gross Debt Service (GDS) ratio
To qualify for a loan, your monthly housing costs must not be more than 32% of your gross monthly income. Housing costs include the mortgage payment (principal plus interest) and property taxes per month. In case of condos, half of the monthly condo fees are also included. Certain lenders also factor in heating costs.
Total Debt Service (TDS) ratio
Your entire monthly debt load should also not be more than 40% of your gross monthly income. Some lenders allow the TDS to be as high as 44%, and some even as high as 50% but you obviously pay a much higher interest rate to offset the risk these lenders take.
To calculate the TDS, lenders add car loans, credit card payments, line of credit payments etc to the housing costs.
A word of caution: The above assumes that you are not self-employed. In case of self-employed borrowers, lenders base their calculation on net income rather than gross income.
To calculate how much you will qualify for, calculate your GDS and TDS. To simply determine if you can afford the house, calculate the GDS. If it is less than 32% of your gross monthly income, you can afford the payments. To calculate the maximum amount you will qualify for, calculate your housing costs using the TDS equation. For example, if you earn $6500 per month before taxes, and have a $500 per month car payment and $200 per month credit card payment, assuming a 40% TDS ratio, your max allowable housing costs will be $1900.
If you are considering buying a house with a yearly property tax of $2400 and your lender does not factor in heating costs, the maximum mortgage payment you may qualify for is $1700. Assuming that you were qualified at an interest rate of 5% compounded semi-annually not in advance, 25 year amortization, you would qualify for a maximum loan of $292,295.
As you can clearly see, lowering your total debt load will mean that you qualify for a higher amount and or qualify for the same amount but with much better numbers, thus lowering a lender's risk and allowing you to negotiate a much better interest rate.
A good first step is to start improving your finances prior to applying for a loan. Pay off as many loans as you can and apply for a pre-approved mortgage. The pre-approval will ensure that you know exactly what your house price limit is and will also present you as a serious buyer. The pre-approved mortgage rate will remain in effect for up to 60 days, 90 for some lenders. If the mortgage rate increase while you are looking for a home to buy, you are guaranteed a lower rate. If the mortgage rates decrease, the lender will be more than happy to offer the lower rate to you.
