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If you're just starting out in real estate, taking on a mortgage can be intimidating. It's a big financial commitment, and you may be uncertain how much is too much. But looking at the numbers lenders use to gauge borrowing capability will give you a good idea of how much house you can afford.
"Your debt-to-income ratio is what you want to look at," says mortgage broker Chris Peterman. "It's the standard for determining how big a mortgage you can handle."
To determine if your income is sufficient, lenders actually have two qualification standards. The first is the portion of your income that can be spent on housing.
The mortgage industry has determined, for conventional loans, that the number should be no more than 28 percent of your gross monthly income.
The second standard applies the portion of income used to pay all outstanding debts. This considers car loans, credit cards and other debts, including your housing expenses, and should not exceed 36 percent of your gross monthly income.
These ratios are not difficult to figure, but making sense of the numbers can seem daunting. Here's a simple five-step approach to help you make a decision you'll be comfortable with. Step One: Add up your total income. Start with the salary you earn from regular employment, including any overtime, commissions, tips and bonuses. Don't forget to add any child support or alimony you may receive, along with Social Security, disability or retirement benefits, rental income or other revenue sources. Step Two: Figure your monthly debt payments. In this exercise we assume the mortgage you plan to take on will be your primary residence, so don't include your current mortgage or rent payments. Do include any mortgage payments for rental properties, just as you added the income from these properties. For credit cards, automobile and other loans, use the minimum payment. Step Three: Divide your monthly debt by your monthly income. For example, debt payments of $350 with a monthly income of $3,000 would give you a debt-to-income ratio of 12 percent. Step Four: Figure your payment limit. Using the example above, a 12 percent debt-to-income ratio before house payments would mean taking on a mortgage no greater than 24 percent of that $3,000 income. That pencils out to payments of around $720 per month, including taxes and insurance.
If you have high living expenses, you might want to lower your debt-to-income ratio below the maximum. While loans are made to borrowers with even higher ratios, experts advise against it. "Even at 36 percent, you probably won't be taking any trips to France," says Peterman. "Get much above that and most people are going to be so strapped for cash they may not be able to handle any unexpected expenses."
Step Five: Armed with your debt-to-income ratio, perform a variety of "what ifs" to see how changes in mortgage terms and interest rates can affect your buying power. A loan amount of $85,000 at 9 percent for 20 years (monthly payments: $765 plus insurance and taxes) may raise your ratio to an unacceptable level, while a $100,000 loan at 7.25 percent with a term of 30 years (monthly payments: $682 plus insurance and taxes) might be more affordable. Don't forget the Internet: If you just don't want to deal with the math--don't. A lot of mortgage information sites on the Internet let you type in some simple information, then they do the calculations for you. One of the best online calculators we've found is Homepath, a Fannie-Mae-sponsored site that features a variety of mortgage and income calculators. Check it out at www.homepath.com.
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