Personal Finance Essentials

How Much to Pay for Your Home

Understand Lending Limits, Avoid Common Pitfalls,

and Calculate Your True Buying Power

HowMuchtoPay

The Two Lending Limits

Lenders use two main ratios to determine how much they will lend you. The first is the payment-to-income ratio: your monthly mortgage payment, including property taxes and insurance, should not exceed 28% of your gross monthly income. For someone earning $60,000 per year ($5,000 per month), this means a maximum payment of about $1,400 per month, which at a 6% interest rate allows borrowing roughly $233,000. The second is the total debt ratio: your mortgage payment plus all other monthly debt obligations should not exceed 36% of gross income. If you already have $800 per month in car loans, student loans, and minimum credit card payments, your maximum mortgage payment drops to $1,000 per month — which at 6% allows borrowing only about $167,000. The more existing debt you carry, the less home you can buy.

The Two-Income Trap

A particularly common mistake is buying a home based on two incomes when one of those incomes might not always be available. Consider a couple who each earn $50,000 per year. Combined, they earn $100,000 and qualify for a much larger mortgage than either could support alone. If one partner later stays home with a child or loses a job, the couple can no longer afford the payments. They made a thirty-year financial commitment based on circumstances that changed in year two. Never make a financial decision lasting thirty years based only on today’s situation.

Four Steps to Determine How Large a Mortgage You Can Get

Determining your purchase price ceiling follows a straightforward formula: available cash plus the maximum amount you can borrow equals the maximum purchase price. Here are the four steps to work through it.

1
Determine how much cash you have or can raise. Include checking accounts, savings, mutual funds, stocks, bonds and gifts from family members.
2
Calculate your gross income. Include all sources: salary, overtime, commissions, bonuses, dividends, business income, pensions, Social Security, veterans benefits, alimony and child support.
3
Tally your existing monthly debts. Include car payments, alimony or child support, student loans, minimum monthly credit card payments and any other obligations lasting 10 or more months.
4
Determine current interest rates. The rate and loan type you choose will determine your monthly payment and therefore how large a loan you qualify for.

Home Equity: What It Is and How to Think About It

Home equity — the difference between what your home is worth and what you owe — is often thought of as wealth. In a narrow sense it is. But equity sitting in a house is illiquid, earns no return, and in a crisis is often inaccessible at precisely the moment you need it most.

A mortgage is a loan against your income and assets — not against the value of your house. Lenders ask one question: how will you repay? If you have no income, you cannot borrow, regardless of how much equity you have built up. This fact is critical.