The first thing you should do, even before starting to look at houses, is to find out what price house or condominium you can afford. Roughly speaking, you can afford to buy a home equal in price to approximately three times your gross annual income.
More precisely, the price you can afford to pay depends on six factors: 1) Your income; 2) the amount of cash you have available for the down payment, closing costs and cash reserves required by the lender; 3) your outstanding debts; 4) your credit history; 5) the type of mortgage you select; and 6) current interest rates.
Lenders are interested in the housing-expense-to-income ratio and the overall debt-to-income ratio.
Your housing-expense-to-income ratio is determined by calculating your projected monthly housing expense, which will consist of the principal and interest payment on your new home loan, property taxes and insurance. The sum of these costs is referred to as PITI.
Projected PITI is divided by your gross monthly income (your income before taxes are deducted). Let's say your gross annual income is $50,000, or $4,167 a month (your annual income divided by 12 months). If your projected PITI is $1,300, your housing-expense-to-income ratio would be 31 percent ($1,300 divided by $4,167).
Monthly homeowners' association dues, if you're buying a condominium or townhouse, and private mortgage insurance, if it's required by the lender, will be added to the PITI in qualifying you for a loan. PMI protects the lender in case the buyer defaults. It usually costs about one-half of 1 percent of the loan amount for the first-year premium.
Your overall debt-to-income ratio is determined by adding your monthly housing-expense figure to the amount you pay per month on outstanding debts and then dividing this figure by your gross monthly income. For instance, if your only outstanding debts are a car loan on which you pay $125 a month and a student loan on which you pay $75 a month, your debt-to-income ratio, using the above example, will be 36 percent. To arrive at this figure, add $125 and $75 to $1,300, for an overall monthly debt figure of $1,500. Then divide $1,500 by $4,167 (your gross monthly income).
Your housing-expense-to-income ratio should fall in the 28 percent to 33 percent range, although some lenders will go higher under certain circumstances. Your total debt-to-income ratio should be in the 34 percent to 38 percent range.
Your ratios limit the size loan a lender will give you. This loan amount, added to the cash you have for a down payment and closing costs, will give you the approximate price home you can afford.
FIRST-TIME TIP: Affordability increases as interest rates decrease.
THE CLOSING: What you can qualify for may not be what you feel comfortable paying per month for your housing expense. It doesn't make sense to exceed your comfort level if you're on a fixed income, if salary increases are uncertain or if it will cause you to lose sleep at night.
Dian Hymer's column is syndicated through Inman News Features. Send questions and comments care of Inman News Features, 5335 College Ave., No. 25, Oakland, Calif., 94618.