From the basic human need for safety to more secondary needs like the pride of ownership, the need to own a home is quite a compelling one. As an intending homeowner, you have most likely asked the question, “why do I need a home?”. The next question you need to answer is, “how much can I afford to spend on a home?”. The answer to these questions can be answered from two different perspectives: the lenders and the borrowers.
The lender: Spend on a home with their consultation
When you conclude your plans to buy or spend on a home, your next move will be to approach a mortgage bank or some other financial institution for a loan. These companies receive thousands of borrowers like you every year. So, they have certain criteria they use to determine who to lend money to and how much. This is to ensure that only those who are most likely to repay are given credit. To make this decision, the lenders use a model called the Debt-To-Income (DTI) Ratio.
Debt-to-Income Ratio (DTI)
This is the measure of an individual’s monthly debt against their income. It is an important step to know how much you can spend on a home. It is calculated by dividing the total monthly debt repaid by total monthly income (TMD/TMI×100). For example, an individual who earns $4,000 monthly (before tax), and pays a debt of $1,500 monthly (car loan, student loan, etc.) has a Debt-To-Income Ratio of 36%. The ratio is calculated before taxation as taxes are not considered debts. While the DTI ratio is often calculated, some borrowers may offer to calculate annual income.
Who uses the DTI Ratio?
All financial institutions involved in granting loans make use of the DTI Ratio. Specifically, the ratio is used when considering applications for general loans, car loans, mortgages, etc. An applicant with a low DTI ratio has a good loan history and therefore doesn’t pose a high risk of default. Such an applicant is therefore attractive and has a high chance of approval. On the other hand, applicants with high DTI ratios are considered high risk and therefore likely to be denied.
After its calculation, the institution will decide whether to lend or not. If it decides to, the ratio will further determine specific aspects of the loan such as amount, the term, and interest. Generally, lenders consider applicants with a ratio of not more than 43%. However, most would prefer those with lower ratios as it suggests how much of their income is left after debt deduction. For example, an intending homeowner with a Debt-To-Income Ratio of 15% has about 85% of their income left after paying their debts. On the other hand, one with a DTI ratio of 45% has a mere 55% left from their income after servicing their debts.
The Borrower: Spend on a home wisely
Apart from the lender, a borrower can equally make a personal assessment of their finances to determine how much they can spend on a home. Specifically, the following factors will determine the amount you can spend on a home.
Your income is the most critical indices in determining how much you can spend on a home. While the banks may consider it when measuring your DTI Ratio, you have to measure your income against your expenses (including existing loans and taxes) as an individual. After this, you now have to factor in the mandatory monthly (or weekly) mortgage repayments.
Savings are essential for emergencies and investments. When applying for a mortgage, the initial/down payment should come from distinct savings. Initial payments can cost between 20-30% of the total mortgage. This means that, usually, they cannot be made from the borrower’s regular income.
Lastly, the monthly mortgage repayments (including principal and interests) will determine the price and how much you can spend on a home. The monthly repayment is the most crucial factor from the viewpoint of the borrower. This is because the inability to meet up (default) will lead to a foreclosure of the home. A homeowner is therefore expected to make regular monthly payments until the entire loan has been cleared.
The mortgage sector is fierce and highly competitive. An assessment of all of the above will determine how much you can afford to spend on a home, including interest, term, etc. This will increase your chances of getting a loan and subsequently reduce your chances of defaulting.