Audio Version: Let Me Hear It!
Work, spouse, children, friends, health, philanthropy… life is one big balancing act of competing priorities. Just as we strive to find balance with our time, it’s also important to balance financial priorities. Since buying a home is one of the largest financial purchases we make, it is one of the easiest ways to get out of financial balance. To understand your options, it’s 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 for the amount that a lender would be willing to extend, there are a two key ratios to understand:
- Debt-to-Income Ratio (DTI): Lenders typically require that all debt payments, including your potential mortgage payment, credit cards, car notes, child support, student loan debts and any other liability payments, be no more than 36% of your monthly gross (before-tax) income. This limit may 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.
- 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) do not surpass 28% of your monthly gross income.
Be careful before making a purchase decision based on a lender’s definition of affordability and 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 or other financial priorities?
Will our expenses increase in the future (i.e., children, college, and care for aging parents)?
Will we be able to comfortably spend on other priorities like travel, private school or personal care?
Despite what a lender might think, you may decide that allocating 28% of your income towards a new home is not practical. On the other hand, living in your dream home may be well worth it to you. After careful consideration, the decision is all yours!