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How Much House Can You Afford?

Knowing how much house you can afford largely depends on your monthly obligations in contrast with your gross monthly income. Let's use an example and breakdown the essential factors that determine an affordable mortgage.

Ruth's annual gross income is $70,000, with her current annual debt amounting to $3,000. Using the debt-to-income ratio, we can derive how critical or minute her debt really is. The debt-to-income (DTI) ratio works by dividing the amount of debt with the gross annual income: 3,000 ÷ 70,000 = 0.043, or 4.3%. Ruth's DTI percentage is extremely well-suited to meet the requirements put forth by even the most stringent lenders. She can comfortably afford a mortgage on a house that's worth $308,000.

Ruth's Income & Mortgage Data
Annual Income Down Payment Monthly Debt Debt-to-Income (with Mortgage) Interest Rate Loan Term Taxes and Insurance? Property Tax Homeowner's Insurance (per year) Mortgage Insurance (per month)
$70,000 $20,000 $250 36% 3.875% 360 months Yes 0.9% $800 $182

Using the example mentioned, try to compare your figures with the ones included here to draw a picture of what you can expect from a loan. How much house you can afford largely depends on understanding the relationship between your financial capacity and that of the mortgage instruments.

What Determines an Affordable Mortgage

Annual income: This can be a combined income (before taxes) of more than one mortgagor which can incorporate their alimony, child support, tips, salary etc. 

Down payment: The most suitable down payment expected from most homeowners is 20%. The more down payment you give for a mortgage, the lower the interest costs will be, and the shorter the loan term can be. Furthermore, a larger down payment will reflect well on your home equity, which you can later use to be financed into paying the principal amount, or converting into hard cash.

Click here for more on cash-out refinancing.

Monthly debt: This can be the combined debts of more than one mortgagor. These debts include vehicle, credit card, taxes, alimony, and child support debts. Remember that your current annual debts should not exceed 36% of your gross annual income. 

Interest rates: With a fixed-rate mortgage (FRM), the initial interest rates will typically be higher than those of adjustable-rate mortgages (ARMs). Each rate variant has its own strengths and weaknesses. FRMs, for instance, may have higher rates but they give you unrivaled budgeting predictability throughout the 10, 15, 20, and even 30 years of the loan's life. ARMs have lower initial interest rates than FRMs but can be tricky once they start to fluctuate.

The debt-to-income (DTI) ratio, as illustrated above, is a simple and easy method of determining just how much of an impact a mortgage can have on accumulating debt. The standard DTI for most homeowners should be no greater than 36% of their monthly income. Exceptions do exist with FHA loans or VA loans that are a lot more affordable for low-income single family homes.

Homeowners insurance: Sometimes referred to as hazard insurance, homeowners insurance protects the lender more than it does you. The lender is calculating just how much of a risk your property is going to be. A homeowners insurance gives you and the lender some peace of mind with regards to the property, especially if it's located in an area with frequent natural disasters.

Mortgage insurance: This is requested mostly when a mortgagor makes a down payment that's less than 20%. It is paid in terms of monthly interest rates that go towards the principal amount of the loan. It also protects the lender if you go into a default. The FHA, for example, allows you to take out a loan with a down payment as little as 3.5%, they get some of that money back in the form of mortgage insurance premiums (MIP).

Closing fees: You won't be given a loan without sealing the deal and signing on the dotted line. The closing costs of a mortgage can be anywhere between 2-5% of the loan amount. The fees are distributed between the seller, lender, and all third-party affiliates who contributed to the transaction (i.e. escrows, recorders, surveyors, realtors, attorneys, couriers, etc.)

For more information on the costs and process of closing a loan, click here.

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