With increasing numbers of foreclosures after 2008, both borrowers and lenders are thinking more carefully not just about how large a mortgage loan a borrower can be approved for but how much is affordable and wise to borrow. This depends on a number of factors, including your down payment or home equity, how much of your income is going toward debt payments, how long you have to repay the mortgage and the interest rate. Learning more about how these factors come together can help you make a sound decision as to what is an affordable mortgage.
Down Payment or Home Equity
Many lenders will not approve mortgages for more than 80 percent of the home’s value. If you’re purchasing a new home, this means you must have a down payment of at least 20 percent of the home’s value. If you’re taking out a second mortgage on a property you own, this means the mortgage must be less than 80 percent of the home’s value minus any outstanding mortgages or loans that use the home as collateral. Mortgages insured by the Federal Housing Administration (FHA) may lend up to 96.5 percent of the home’s value. However, interest rates on these mortgages are slightly higher, and you must pay down to 78 percent of the home’s value within five years, something harder to do with small down payments. Until that time, you must pay FHA insurance premiums.
Your mortgage’s interest rate is the cost of borrowing that money. The lower this rate, the lower your monthly payment and thus the larger the amount you can afford or may be approved to borrow. The loan’s interest rate is determined by a number of factors, including market conditions and your credit score. Interest rates are slightly higher for loans that have longer repayment periods and lenders or allow smaller down payments. Unless you have a fixed-rate mortgage, interest rates can change during the life of the loan, affecting your monthly payments and potentially whether they’re affordable or not.
The longer your repayment period, the lower your monthly payments. However, you’ll pay more in total interest over the life of the loan because you’ll be paying interest for a longer period. For example, an $80,000 mortgage with a 7 percent interest rate paid over 15 years has a monthly payment of $719.06 and total interest payments of $49,431.27. The same mortgage amount and interest rate paid over 30 years has a smaller monthly payment of $532.24 but you’ll pay more than twice as much in a total interest payment of $111,607.12.
A lender is unlikely to approve a mortgage if its monthly payments, homeowner’s insurance premiums, condo fees (if any) and your other debt payments (e.g., credit cards, student loans, car loans, etc.) add up to more than 36 percent of your gross or pre-tax income. In lenders’ terms, this means that your debt-to-income ratio must be less than 0.36. To calculate this percentage, add up your monthly debt payments and divide by your monthly gross income. Lenders are increasingly stringent in their documentation requirements for borrowers to prove they have the income to make the monthly payments.
Calculating Mortgage Amounts and Payments
If you earn $48,000 a year or $4,000 per month before taxes, your maximum monthly mortgage, housing and other debt payments must be less than 0.36 times $4,000, or $1,400, to fall within the acceptable debt-to-income ratio of 0.36. Of that $1,400, if you pay $400 in monthly credit card and car loan payments, then your monthly mortgage and homeowner’s insurance premiums must be less than the remaining $1,000. This means that if you have $20,000 available as a down payment, then you could take out an $80,000 loan at 7 percent interest over 15 years because your monthly payments would be $719.06, well under the $1,000 limit.