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What measures determine home affordability? Mortgage lenders have traditionally expected borrowers to have a housing expense ratio of 28% or less. The housing expense ratio indicates a borrower’s ability to make the payments on their mortgage loan. The ratio measures housing expenses as a percentage of gross income (income before Social Security, Medicare and tax deductions). For example, if a borrower’s salary were $4,000 per month, a lender would want to see the housing expenses (mortgage payment, insurance, property taxes, etc.) were less than $1,120 per month. $1,120/$4,000 = 0.28.
In addition to the housing expense ratio, lenders also consider a borrower’s total expenses: housing expenses plus fixed monthly obligations. By traditional lending standards, total expenses could not exceed 36% of gross income. In other words, continuing the previous example, a borrower with housing expenses of $1,120 per month and fixed monthly bills of $350 would have $1,470 in total expenses per month. The total expense ratio would be 36.75% ($1,470/$4,000 = 0.3675), and the lender would not approve the loan.
In recent years, however, lenders have relaxed the rules, allowing many people to get approved for mortgages they really couldn’t afford. That left the borrowers and lenders in financial trouble, with homeowners defaulting on their mortgages and some lenders struggling to avoid bankruptcy. As a result, lenders have become more careful about extending loans and have adopted more conservative lending standards.
People often want more house than they can afford. (You can use this calculator to figure out how much house you can afford, based on your potential down payment, income and debt obligations.) Perhaps it’s human nature to want to stretch: In our consumer-oriented society, there are a lot of forces telling you to buy a bigger, or faster, or better thing than what you need. As tempting as it all is, you must avoid this mindset. Overspending creates financial problems that can be a source of stress and have negative effects on your marriage, family relationships and, of course, your financial health.
A few things can happen when you can’t afford your mortgage payments. First of all, payment history is the most influential factor in credit scores, and a payment that’s 30 days past due can knock dozens (even 100) points off your credit score. If you continue to miss payments, your credit score will suffer further, which is why it’s crucial to make sure you can afford your mortgage. (Just as it’s important to check your credit before applying for a home loan, you’ll want to see how your mortgage affects your credit throughout the life of the loan. You can get two of your credit scores for free on Credit.com.)
As soon as you realize you’re in danger of missing home loan payments, explore the options you may have to save your home from foreclosure. You may be able to refinance (if your credit is in good standing), ask your lender for a break, take advantage of a loan modification program or find a way to cut your losses and move on. All these options have significant implications for your financial stability, but having a foreclosure in your credit history can cause you financial stress for years, as well.
The likelihood of foreclosure shouldn’t be your only concern when determining how much house you can afford. Your ultimate goal is to make sure that homeownership is a joy. Establish your own spending limits that allow you to continue saving, and to continue to live a lifestyle that makes you happy. It’s up to homebuyers to make sure they aren’t stretching beyond what they can truly afford.
Budgeting is the key to having a happy, secure financial life. Prepare a household budget and stick to what you can conveniently afford, despite the temptation to buy a bigger home or spend more money on other amenities.
These guidelines can help you to develop your own housing cost limits:
Now you can calculate your own ratios. Here’s an example using simple numbers for ease of calculation:
Say your rent is $1,000 per month and your gross income is $3,000 per month. Your housing expense ratio is $1,000/$3,000 = 0.33 (33%).
Next add your other expenses, say $300 per month. The total expense is then $1,300 and your total expense ratio is $1,300/$3,000 = 0.43 (43%).
A lender would say that your ratios are “33 over 43.” Note that these ratios are higher than the traditional 28 over 36, but your mortgage might still get approved.
Now think about how comfortable you are at this level. Perhaps you are single or have no kids and you are able to save money every month. There’s still some room in the budget even though the ratios are a little high. Other borrowers with the same numbers but with two children might feel stressed on this budget.
To learn more about buying a home and how the financing process works, read more from our experts by visiting our Mortgage Learning Center.
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