There can be a big difference between how much house you believe you can afford and how much a mortgage lender thinks you can buy. Your purchasing power is determined by comparing monthly debt payments to gross salary. Some lenders are willing to allow a higher portion of your salary to go toward mortgage payments, which increases your buying power, while others have more conservative debt-to-income ratios. The maximum loan amount a lender is willing to finance differs from your maximum purchase price. Your down payment, plus your max loan amount, determines the price of the home you can buy.
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Housing DTI Ratio is Only One Factor
Lenders prefer a housing DTI ratio of 28 percent. That means that your monthly mortgage payment, including principal and interest, plus monthly property taxes, homeowners insurance and homeowners association fees, can't exceed 28 percent of your monthly salary. The housing DTI ratio is also known as the front-end ratio ; it is the first of two DTI ratios that lenders use to calculate how much house you can afford. Some lenders and loan programs offer higher DTI ratios if your case includes certain favorable factors, such as a high credit score, a large down payment or good reserves.
Total DTI Includes Other Monthly Expenses
A second DTI ratio includes your housing payment plus recurring monthly debts, such as minimum payments on credit cards, car payments, child support, and student loan payments. This figure is known as the "total DTI" or back-end ratio and is typically capped at 36 percent. If other compensating factors exist, the lender may accept a higher back-end DTI. In some cases, such as those involving Federal Housing Administration and Veterans Affairs loans, lenders may allow a higher debt load, with a back-end DTI in the 50-percent range.
Sample DTI Calculations
You can calculate the maximum monthly payment a lender is likely to allow based on your salary. Say your annual salary before taxes is $54,000, and your monthly gross income is $4,500 ($54,000/12). You have $15,000 in credit card debt and the minimum payments on those cards is $500 per month. Assuming a max back-end DTI of 36 percent, you can afford to pay up to .36*$4,500, or $1,620, for housing and recurring expenses. With this figure, you can then find out how much of a housing payment you can afford by subtracting $500 from $1,620, which equals $1,120. The difference is $1,120. Because $1,120 is only 25 percent of your monthly salary ($1,120/$4,500), you are well within the allowable front-end DTI range of 28 percent.
Down Payment Also Affects Purchasing Power
Most lenders only finance a portion of a home's price and it's usually no more than 97 percent. You must come up with the difference -- the down payment. The larger your down payment, the more house you can afford on your salary. For example, if a lender is willing to finance a loan amount up to $140,000 based on your salary, and you have $60,000 as a down payment, you can buy a $200,000 house. However, if you only have $10,000 for a down payment, you can only afford a home price of $150,000.