Many renters are tired of having a place they don’t feel they can really call their own, but are hesitant to jump into homeownership because they don’t know how much they can afford. Determining how much house you can afford is an important question to answer before beginning the search process for a home, or a rent-to-own home. The answer to this question is a bit complicated, so let’s break it down into digestible chunks.
DTI (Debt to Income) Ratio
DTI, or debt-to-income ratio, is the first thing to consider when figuring out what you can afford. Your DTI is essentially how much you owe vs. how much you earn. To calculate your DTI first add up how much you owe in debts every month. Debts in this case are things that you actually owe money on like loan payments or credit card payments. Do not include things like utility payments or gym memberships. Once you’ve got your monthly debt number divide that by your monthly income. e.g. $600 monthly debt / $3,700 monthly income = 16.2% DTI.
Now it’s time to calculate your potential mortgage payments. We’ll use the current prime federal interest rate of 3.5% and the average home price in the United States $222,700 as our example. There are some very simple mortgage calculators out there but it’s pretty easy to get a rough idea of how much a mortgage payment will cost you per month. This calculation is done in two parts. First you’ll need to calculate principal and then interest and add them up to get the total mortgage payment.
Principal – To calculate the portion of your principal payment is actually pretty simple just drop off the last three digits of the $222,700 and the portion of the principal payment is roughly $222
Interest – Interest is a fairly simple calculation as well. Simply take your interest rate 3.5% and convert it to a whole number 0.035 then divide that by 12 to get the monthly interest rate (0.035 / 12 = .00291) now multiply the monthly interest by the loan amount to find the interest paid per month (.00291 * $222,700 = $649.54)
Add it up. Now just put together your principal and interest to find the total mortgage payment. $222 + $649.54 = $871.54.
Putting it together
Now that you know your DTI and how much a mortgage payment is on the median home in America, you can figure out if you can afford it. Most lenders believe that a 36% total DTI including your mortgage is acceptable risk. It may be better for you to keep this percentage closer, or even under, 30% to avoid being house poor. If we take the $871.54 mortgage payment and add it up with the debts we mentioned earlier of $600 and keep our monthly income at $3,700 we can quickly find out if we can afford this home.
($600 + $871.54 / $3,700 = .3877 or 38.7%)
At 38.7% DTI after taking on this mortgage we’d likely not qualify for this loan.
Take some time to figure out your financial situation and see how much house you can afford. Remember there are always alternatives to a traditional mortgage; one of those alternatives is a rent-to-own home which can let you live in and rent the home that you’ll buy later down the road after building up savings and building up your credit.