When you look for a home, you’re looking at factors such as price, location, décor and size. When a lender looks at the amount of mortgage loan you qualify for, he or she is only interested in finances.
The lender compares your monthly income to your monthly bills to determine your debt-to-income ratio. It’s pretty easy; the lender adds up your monthly debt payments and divides them by your gross monthly income.
For example, if you pay $1,100 a month in rent, $400 a month for a car loan, and $500 a month for the rest of your debts, your monthly debt payments equal $2,000. If you make $60,000 per year, your gross monthly income is $5,000. That would make your debt-to-income ratio 40 percent.
Lenders have determined that borrowers with a high debt-to-income ratio default more often than those borrowers with a low debt-to-income ratio. What qualifies as high or low? While there isn’t a fine line—all lenders are different—many lenders prefer a 43 percent or lower debt-to-income ratio.
If your debt situation resembles the above example, don’t expect to qualify for a loan that requires you to pay much more than $1,100 per month. That amount includes the mortgage loan payment as well as any points and insurance.
So, how much house can you afford? Well, only a lender can tell you for sure, as that ratio doesn’t translate easily to a purchase price. A loan’s interest rate and other terms can greatly affect the amount of money you can afford to borrow.
However, calculating your debt-to-income ratio is a good exercise when you start looking at mortgage loans. You’ll know whether your current housing costs are sustainable in a lender’s eyes, and how much additional money you could afford to allot toward a mortgage.