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LESSON 2: Find Out How
Much Home You Can Afford
Before you even begin to think about what type of home you want
or what neighborhood you would like to live in, you�ll need
to determine what you can afford. The answer will depend, partly,
on the amount of cash you can bring to the purchase. But more importantly,
consider how large a monthly payment you can afford based on your
income and other debt obligations.
Lender Standards
Lenders use a set of ratios to determine the maximum loan payment
they think borrowers can handle without getting financially overextended.
Most (though not all) lenders use 28% and 36% limits.
The 28% limit is the maximum amount of your gross monthly income
that can be used to pay principal, interest, taxes and insurance
(PITI). For example, if you have gross earnings of $5,000 per month,
the 28% standard would limit your PITI payment to no more than $1,400
per month. With a 7% interest rate on a 30-year mortgage, that $1,400
payment would qualify you to borrow about $208,000 (depending on
the cost of insurance and taxes).
But wait! You still have a 36% limit to worry about. This second
ratio holds your PITI payment plus all your other payments for long-term
debt (e.g., credit cards, car loans, etc.) to no more than 36% of
your gross monthly income. Say you earn $5,000 per month and have
monthly installment payments totaling $600 per month. The 36% test
would limit your PITI payment to just $1,200 (.36 x $5,000 = $1,800;
$1,800 - $600 = $1,200). At that payment level, you could borrow
about $180,000.
Add your down payment to the lower of the two amounts the ratios
qualify you to borrow, and you�ll know the top price you can
pay for a home. (Of course, your actual numbers will vary from those
above; give us a call to find out how much you could borrow based
on your particular income/debt situation.)
Beyond Ratios
Bear in mind, just because a lender is willing to loan you a certain
amount of money for a home purchase doesn�t mean you should
borrow that much. The ratios yield a maximum amount, which may be
too much for some borrowers to handle realistically.
Say you live in an area with a high cost of living, or you have
an expensive hobby, or there are additional debt obligations on
the horizon -- college tuition, elder care, child care. The 64%
of income you have left over (after 36% goes to your PITI and debt)
may not be enough to cover all your other expenses comfortably.
You could end up living �house rich and cash poor,�
perhaps even defaulting on your home loan.
On the other hand, borrowers who know their income will increase
steadily in subsequent years, or who are close to retiring some
long-term debt, may want to take the full amount offered by a lender.
You may even want to increase the amount of money you qualify for
by retiring some of your long-term debt before applying for a loan.
Another way to maximize your loan amount is to shop for a lower
interest rate -- the lower the interest rate, the more principal
you can afford to borrow.
ANY QUESTIONS? We�d be happy to answer your specific questions
about your particular situation.
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