How much mortgage can I afford?
You have decided to buy a house and realize the American dream. But first thing first: you must ask yourself the question, "How much mortgage can I afford?"
Typically the bank looks at two factors:
1. Front end ratio: This is the ratio of your mortgage payment to your income. Most mortgage lenders require that the maximum ratio be between 28% to 32%. This means that, if your monthly income is $10,000, your mortgage cannot be more than $2,800 to $3,200.
2. Back end ratio: This is the ratio of your total expenses to your income. Most mortgage lenders require that this does not exceed 36%. In addition to your mortgage payment, your credit card payment, car payment, child support, and any other loan payments. This means that, if your monthly income is $10,000, your total expense cannot exceed $3,600.
So, you have used the mortgage affordability calculator to find out that you can afford a $350,000 mortgage. However, you'd really like to get a $400,000 mortgage because that's what it would take to move you into that dream house you have spotted. What can you do?
There are ways to afford a higher mortgage than , for example getting an adjustable mortgage, where your interest rate stays constant for a period of time (typically 3 to 10 years), and then can adjust annually based on some type of interest index. The advantage of this type of loan is that your initial interest will be lower, thus with the same front end ratio and back end ratio, you can get a bigger mortgage. The disadvantage is that, at the end of fix-rate term, your mortgage payment can go up significantly because of the interest rate adjustment.
To get an even bigger mortgage amount, you can go with an interest-only mortgage. In this type of mortgage, you only pay the interest on your loan for a specified amount of time (typically 5-10 years). However, because you have not paid down your principal, your payment increase at the end of the your interest-only term can be quite substantial.
There are other creative ways to afford a bigger mortgage, such as using a negative amortization mortgage, where you pay less than the full interest amount every month. It is my view that such loans are extremely risky, and should be avoided if at all possible.
One thing to keep in mind is that you don't need to stretch yourself and take the biggest mortgage (and thus buying the biggest house) that the bank is willing to give to you. Stretching yourself to the maximum typically means that after you get the house, you'll get the feeling that you are working so hard to earn money just to keep up with the mortgage payment. Your life quality will likely be better if you get a smaller mortgage to give yourself some leeway with your monthly income.