You might have a monthly payment figure in mind when you start shopping for a mortgage and it may not necessarily be based on your income, but rather, what you're comfortable paying. Lenders, however, work differently. They begin with your income to deduce the maximum monthly payment you can afford. Lenders use gross, verifiable income from all borrowers on the loan. That means that you must document your income -- usually for the past two years -- and show that it is stable and likely to continue after you get the mortgage.
Making the highest payment your income allows can leave you house rich and cash poor. Financial experts advise putting part of your monthly income toward savings, an emergency fund and long-term financial goals. However, homeowners who spread themselves too thin have a hard time contributing towards retirement, reserves and even essential monthly expenses. Lenders use a unique set of standards to determine how much of a mortgage payment you can afford. But the percentage your lender believes you can put toward a mortgage often exceeds the recommended 30-percent prescribed by financial advisers.
What Counts As Income
Lenders Look at DTI Ratios
A front-end debt-to-income ratio is the percentage of your monthly income used to make your mortgage payment. For loan-qualifying purposes, your mortgage payment, including principal and interest, is bundled with monthly property taxes, homeowners insurance, and homeowners association and mortgage insurance. Maximum allowable front-end DTI ratios can vary widely, depending on the lender and loan. For example, a front-end DTI of 28 percent or less is ideal to lenders, however, the most flexible front-end DTIs go up to the high 30-percent range.
Affordability Doesn't Only Depend on DTI
Just because your lender is willing to approve a high front-end DTI, doesn't mean you should get the mortgage. Financial advisors recommend keeping your total monthly debts at or below 36 percent of your gross income. That means your monthly mortgage payment, plus auto loans, credit card payments and other recurring monthly obligations should equal no more than 36 percent of your household income. If your DTI is high, you should eliminate other monthly debts. Or, if you must carry monthly debts in addition to a mortgage, make sure your front-end DTI for the mortgage is well below 36 percent.
Consider Other Homeowner Costs
Your lender takes into account only the monthly costs directly associated with owning your home, but it doesn't consider the cost of maintenance and utilities. Homeowners who take on a mortgage payment that consumes a greater percentage of their income are at greater risk of default should medical problems, job loss, or another emergency strike. If a high DTI is needed to buy a bigger home, it may also result in higher energy costs and more upkeep. Additionally, homeowners insurance costs can rise on an annual basis and your property taxes can also rise as your home's value goes up. These increased expenses can lead to a higher-than-expected housing payment over time.
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