When answering this question, consider that there is a difference between the purchase price you can qualify for and the purchase price you can afford to pay. Most lenders, good lenders, will not qualify you for a loan that requires you to spend more than about 1/3 of your monthly income on your home loan. To asses this, lenders will, of course, review your monthly income, but they will also look at your debt-to-income ratio. This figure is arrived at by adding up all of your monthly debt obligations – including the mortgage you are considering, the taxes and insurance on the property, and any other contractual obligations that you have, such as car payments, credit card payments and student loans – and dividing the total by your monthly gross income.
Most lenders will allow you a total debt-to-income ratio of 36 percent or less. This is because studies of personal finance have shown that this is the most financially stable position (besides being debt-free) for a person. After all, besides paying off debt, your monthly income still has to put food in your month and clothes on your back. Then there’s health care, entertainment and incidental costs.
Now, unless you were paying close attention and have some knowledge of finance terminology, things seem good so far. Not quite. Notice that the debt-to-income ratio uses your gross income, not your net income. Your gross income is the amount your employer pays you, but your net income is the amount that actually goes into your bank account to be used for paying debt and bills and other expenses. Depending on your tax elections and other paycheck deductions such as health insurance and retirement deductions, your net income can be as much 20% less than your gross income. When you consider that, suddenly, the ideal 36% debt-to-income ratio becomes almost 60%. That’s where the trouble begins.
Ideally, you should be spending about 25% of your gross income on your home and 10% on other debt. Now, how many people do you know who only have debt equal to 10% of their net income? Not many, I’d wager. Well, that’s the same problem mortgage lenders face. But they’ve got to stay in business somehow, so not only do they use misleading figures to determine whether they’ll lend you money, but they also are increasingly lending to people who have higher than a 36% debt-to-income ratio.
So, what’s the moral of this story? Mortgage lenders are not your friends; they are not looking out for your financial interests; they are only looking to make as much as quickly and easily as possible. Given that, how do you look out for your own financial interests? How do you figure out how much house you actually can afford? Easy: figure your debt-to-income ratio using your net income.