The journey toward homeownership is undoubtedly an exciting one, but also one fraught with questions that can send even the most ‘zen’ individual into a tailspin. Of these questions, the first – and perhaps the most crucial – one that you should ask yourself when starting the homebuying journey is: how much home can I actually afford?
It’s certainly worth taking the time to figure this out, potentially saving yourself some major headaches, before you begin sending out the housewarming party invites. But how does one go about calculating this mysterious number, you ask? Your debt-to-income ratio, along with your loan-to-value ratio and your credit score, are three of the main factors that will help determine how much you can borrow. Not quite sure what we’re talking about? Let’s start at the beginning:
Debt-to-Income-Ratio
Your debt-to-income ratio, which lenders evaluate when determining your ability to repay the money you have borrowed, is considered a pretty significant indicator of your financial health. In short, it’s the sum of all your monthly debt payments, divided by your gross (before-tax) monthly income.
Lenders generally want to see no more than 43 percent of your total before-tax income allocated toward your various debt payments, including your new home. For example, if you make $5,000 per month before tax, then your new home payment – plus any existing monthly obligations – should not exceed $2,150 per month.
It’s worth noting that individual lenders may use slightly different formulas when calculating this ratio, but it’s certainly useful to have a ballpark number in mind as you start shopping around for mortgages.
Loan-to-Value Ratio
Whether it’s the product of consistent savings, or an enviably generous gift, your down payment represents the cash you pay upfront when applying for a home loan. This amount is deducted from the total amount of your mortgage and represents your initial equity stake in your property – it’s also how lenders evaluate your loan-to-value (LTV) ratio.
Your LTV ratio represents the amount you would like to borrow as a percentage of the total value of the property you’re looking to purchase. The greater your down payment, the less you’ll need to borrow, all other things held equal. Most lenders tend to give you their best rates if you put down 20 percent or more, as they’re confident that you have ‘skin in the game’ and are deeply invested in your new property. And, of course, better rates usually means lower monthly payments.
No need to despair if your down payment is more modest, though: a lot of lenders still have great options available with down payments as low as 3.5% of the property’s value!
Credit Score
When you apply for a loan, lenders use credit scores to determine your creditworthiness – this is based on a number of factors, including payment history, length of credit history, credit usage relative to available credit, and credit mix (i.e., the various types of debt you’ve managed). It likely comes as no surprise that creditor are looking for indicators that you have a decent track record of managing your debt responsibly and making on-time payments.
Your credit score can have a significant impact on the rates you are offered and, in some instances, may also affect the amount of down payment required. The difference between a good and bad credit score may be reflected in the rates you are quoted, with less favorable credit scores sometimes resulting in a 1.0% or more increase to your rate. While this might not sound like much, it can have a sizeable impact on your monthly payments - and may really add up over the term of your loan.
If you are unsure about how much you can borrow, the best way to find out is to get a pre-approval letter. Simplist’s intuitive technology allows you to get one in as little as five minutes, giving you the confidence you need to begin your home-buying journey. And, if you still feel as though you could use some guidance, don’t hesitate to get in touch – our friendly mortgage experts are happy to extend a helping hand as you climb that crucial first rung on the housing ladder!