How debt and income shape your home-buying budget

Unless you won the lottery and are going to pay in cash, it’s always good to talk to lender to find out what you can afford before you start shopping for a home. But there are steps you can take before then to prepare yourself, mentally and financially. In fact, it only takes a simple assessment of your debts and income to set reasonable expectations on the mortgage and home you can afford.

Understanding DTIs

Today’s lending standards are designed to prevent you from taking out a loan that you can’t reasonably be expected to pay back. In fact, loan originators will analyze your debt and income to determine the most you can afford to pay each month. Ultimately, your monthly payment is going to be determined by several factors, including your purchase price, down payment, credit, interest rate and other loan terms. But after all these factors are plugged into the formula, lenders want to make sure you’re earning enough to cover all your debts, including that new mortgage payment.

This is why loan originators place great importance on your debt-to-income (DTI) ratio. And you should, too. In a nutshell, your DTI is the share of your gross monthly income available to cover all your monthly debt payments, including those on car loans, credit cards, child and spousal support, plus a mortgage payment. For purposes of DTI, your lender won’t consider things such as your cell phone and utility bills.

For most conventional and FHA loans, lenders typically don’t want the sum of your debt payments to exceed 43% of your gross monthly income. That said, you might still be able to qualify with a slightly higher DTI if you have mitigating circumstances, such as a great credit score. The standards are a little different for VA and USDA loans.

By the numbers

For a couple with combined annual earnings of $72,000 a year, or $6,000 a month, the DTI limit would be $2,580. So, if their car payments, credit card bills and other monthly obligations added up to $800, a lender would typically avoid issuing them a loan with monthly payments exceeding $1,780 per month.

As you evaluate your own DTI, it’s important to understand the elements of a monthly mortgage payment. Lenders commonly use the term PITI, the acronym for Principal, Interest, Taxes (property and other taxes on real estate), and (homeowners) Insurance. Additionally, if your down payment is going to be less than 20% of the purchase price, your lender will add mortgage insurance to the payment. And, if you are purchasing a condominium, your association dues will likely also be included.

Discover your payment limit

Calculating your own DTI is a pretty easy two-step process. Start off by multiplying your gross monthly household income by.43. From this number, just subtract the monthly payments you make on your existing loans and debts.

There are many insights you can gain from your own DTI. For example, you can use one of the many mortgage calculators available online to gauge your purchasing power. Just enter your market’s median home price and average interest rates (both can be found through quick online searches), along with your anticipated down payment, into the respective fields. This is usually enough for most online calculators to show an estimated monthly payment. How does this compare to the payments your own DTI ratio will support?

Adjust your budget

You can also use your own DTI ratio to assess your household spending patterns. If you are currently spending less on rent than the amount your DTI would support on a mortgage payment, consider putting the difference into a savings account. Not only will this help you save for a down payment, this could also help you get used to living within the budget you’ll have after you purchase your home.

On the other hand, if you are currently spending more on rent than what your DTI would otherwise allow for a mortgage, buying a home might actually reduce your monthly expenses, assuming you have the resources for a down payment and closing costs. And, if your DTI is reducing your borrowing capacity, it might be time to get serious about reducing some of your debts.

You still won’t want to wait too long to talk to a pro. A licensed mortgage loan originator is going to help you understand the complexities of financing a home, including income and down-payment documentation guidelines, as well as the different types of loans that are available. But understanding your DTI will make it easier to start the conversation.