Before you apply for a home loan, evaluate your personal finances. How much you earn versus how much you owe will likely determine how much a lender will let you borrow. Read on to learn how to do the math. (You can also use realtor.com's Home Affordability Calculator to determine how much house you can afford.)
Add Up Your Income
First, determine your gross monthly income. This includes any regular and recurring income that you can document. If you can't document the income, or if it doesn't show up on your tax return, then you can't list it to qualify for a loan. However, you can use unearned sources of income such as alimony or lottery payoffs. And if you own income-producing assets such as real estate or stocks, the income from those can be estimated and used in this calculation. If you have questions about your specific situation, any good loan officer can review the rules.
Add Up Your Debt
Next, calculate your monthly debt load. This includes all monthly obligations like credit cards, installment loans, car loans, personal debts or any other monthly payment like alimony or child support. For revolving debt like a credit card, use the minimum monthly payment for this calculation. For installment debt, use the current monthly payment. And you don't have to consider a debt at all if it is scheduled to be paid off in less than six months. Add everything up to get a figure we'll call your monthly debt service.
How Lenders Calculate What You Can Pay
Most lenders don't want you to take out a home loan that will overload your ability to repay everyone you owe. Although every lender has slightly different formulas, here is a rough idea of how they look at the numbers.
Typically, your monthly housing expense, including monthly payments for taxes and insurance, should not exceed 28 percent of your gross monthly income. If you don't know what your tax and insurance expense will be, estimate about 15 percent of your payment. The remainder can be used for principal and interest repayment.
In addition, your proposed monthly housing expense and your total monthly debt service combined cannot exceed 36 percent of your gross monthly income. If it does, your application may exceed the lender's underwriting guidelines, and your loan may not be approved.
Depending on your individual situation, there may be more or less flexibility in the 28 percent and 36 percent guidelines. For example, if you can make a large down payment and thus borrow less than 80 percent of the home's value, the qualifying ratios become less critical. Likewise, if a rich uncle is willing to co-sign the loan, lenders will be much less focused on the guidelines discussed here.
Explore Your Loan Options
Remember that there are hundreds of loan programs available in today's lending market, and each has different guidelines. So, don't be discouraged if your dream home seems out of reach.
Also keep in mind that you control a number of factors that affect your monthly payment. For example, you might choose to apply for an adjustable-rate loan, which has a lower initial payment than a fixed-rate program. Or you can make a larger down payment, which will lower your projected monthly payment.