This is a question that should be addressed more often than it is because it’s an important one. A mortgage is a financial commitment and one that buyers will be taking on for quite some time so the proper loan amount and loan terms is very important. Let’s look at how lenders determine how much a first timer should borrow and then get a perspective of what the actual buyers might say.
Lenders use a system of debt-to-income ratios to help determine affordability. When someone first speaks with a loan officer they’re asked to provide some basic information about how much they make each month and any current monthly credit obligations they have such as credit cards or a car payment. The lender then takes no more than 43% of their gross monthly income and subtracts the credit card and car payment for an amount reserved for a mortgage payment. This amount should be approximately one-third of their gross monthly income. Finally, the loan officer then considers prevailing mortgage rates and calculates the amount reserved for the principal and interest payment.
For instance, a couple makes $7,000 per month and one-third of that is $2,100. The loan officer then makes a monthly estimate of property taxes and insurance. If taxes might be $250 per month and insurance $125, the amount remaining would be $1,725. Using a 30 year fixed rate loan at 3.75%, the qualifying loan amount would be approximately $372,000.
But what do the borrowers have to say about this amount? The borrowers have the final say and while they won’t be able to borrow much more than that amount based upon typical debt ratio requirements, they’re not obligated to take the entire loan to buy a home. This is important due to what lenders refer to as “payment shock” and is the difference between what the buyers are paying each month now for rent and the new monthly payment which includes the principal and interest amount, taxes and insurance.
Let’s say the buyers are now paying $1,500 per month in rent and have been for the past two years. The new amount they qualify for is $2,100, or $600 more than what they’re used to paying. They may not feel comfortable making such a jump in housing costs and decide they’d rather pay no more than $1,800 per month. In this example, the new loan amount would be closer to $307,000. Just because the borrowers qualify for a certain amount from a lender’s viewpoint doesn’t mean they’re obligated to take that much of a loan.