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One of the most common questions people ask themselves as they begin house hunting is this one: How much mortgage can I afford?
This questions is fraught with difficulty, since there are many different views as to what constitutes an “affordable” mortgage. And, of course, since this is a personal finance question, the answer will vary, depending on what you are comfortable with. But here are some ideas that can help you determine the affordability of your potential mortgage:
Looking at the true costs of home ownership
The first thing you have to do is look at the true costs of home ownership. It is vital that you understand that the cost of buying a home is about more than just the monthly mortgage payment, which also encompasses interest. Here are some of the other costs you should consider:
- Property taxes
- PMI (if you have it)
- Homeowners insurance
- Maintenance costs
- Costs involved in furnishing a new home
Do your best to estimate your monthly home ownership costs, remembering that it is often better to err on the higher side. There are home expense calculators available online that can help you determine monthly costs.
Deciding if you can afford that home
Once you estimate the monthly costs of home ownership, you need to figure out whether or not you can afford the mortgage of your choice. Many personal finance experts recommend that you spend no more of 1/3 of your monthly income on housing costs. So, if you make $4,500 a month, that would limit your monthly expenses to $1,500. If your costs add up to more than that, you might consider looking for a less expensive mortgage to bring down your total costs.
Another consideration is what is known as the 28/36 qualifying ratio. This is a ratio used by many mortgage lenders to determine whether you qualify for a loan — or at least for the best rate. In this scenario, your mortgage payment should be no more than 28% of your monthly income, and your total monthly debt payments (including mortgage) should not exceed 36% of your income.
More lenders are going back to using this yardstick since the subprime mortgage crash. Prior to the subprime crash, it was possible to get a decent rate (but not the best) on a mortgage with as much as 40% of your income going to debt payments. Some lenders, if you were willing to pay a higher interest rate, would agree to provide you a loan that put some up to 50% to 55% of their monthly incomes. It’s not hard to see, in these situations, how we ended up with a mortgage crisis.
Finally, you should remember that your mortgage loan cost estimate should account for changes to your interest rate. If you are getting an adjustable rate mortgage, or if you have a low introductory rate, you need to base whether or not you can afford your mortgage on what the new payment will be after the interest rate resets. For interest only loans, it is important to base your estimate on mortgage loan affordability on how much you will need to pay once you begin making payments on the principal.
It can be tempting to get a bigger house now with a mortgage loan that appears to be inexpensive initially. However, you are often better off if you can limit the amount of money you pay for a mortgage in the first place. Decide what monthly amount you can comfortably afford — leaving room for unexpected expenses — on housing costs each month. Then choose a mortgage that fits into your budget.