When you're shopping for a new home, the first question you'll ask yourself is, "How much home can I afford?" Price determines location, schools, size, and more. To figure it out, you'll need to calculate a debt-to-income ratio to determine how much of your income will be available for monthly mortgage payments, including principal, interest, taxes, and insurance, collectively referred to as PITI.
Lenders vary in their requirements for your debt-to-income ratio. However, most agree that PITI should not exceed 28 percent of your gross income. The total amount you pay in debt-related expenses, including your mortgage, car loan payments, credit card bills, student loan payments, and any other debts, should not exceed 36 percent of your income. Some lenders may also require that you show a PITI reserve of several months before they approve your loan.
Calculating Your Debt-to-Income Ratio
So how much can you afford to pay each month? The first step is to determine your total income. This includes not only your regular salary, but also the following:
- Regular income from dividends and interest
- Assistance or support payments, such as alimony or child support
- Payment from tips or commissions
The total of all these figures will give you your gross annual income; dividing by 12 will yield your monthly gross income. Multiplying your monthly income by .28 will give you an idea of how much you can afford in monthly mortgage payments.
For example, if your total household income is $80,000, your monthly income is $6,667. At 28 percent, you can afford to spend $1,867 on your mortgage per month. At 36 percent, you would have a total of $2,400 in debt-related expenses per month.
At this point you are ready to consider your loan options and use online calculators to see where you stand. Continuing with the previous example, if you find a mortgage loan with a monthly payment of $1,500, you would be well under your $1,867 limit. Next, factor in your average monthly credit card expenses, car payments, and any other rotating charges. If that total comes to $800, your total debt burden would be roughly $2,300 -- $100 less than your $2,400 limit.
It is ultimately up to you to apply these formulas and ratios to your own financial situation. Remember, while the numbers may help you get approved for a loan, they won't provide you with the whole story. Some people can afford a little more, while others should pay less, depending on lifestyles and other factors.