Two Reasons Why Basing Your Homebuying Affordability on Debt to Income is Dangerous
Over the last decade, I have received thousands of questions from thousands of clients who were thinking about buying a home. I have condensed nearly 20,000 hours of conversations into the top 8 most common questions from future homebuyers. This week, "Can I afford it?".
Part 5: Top 8 Questions for Homebuyers that I've Been Asked
While the home loan and homebuying process can be intimidating, it can be much easier than anticipated when you have an experienced and trustworthy loan officer. In my experience with administering more than 10,000 home loan applications, I found that a large percentage of my clients were either surprised that they qualified for a home loan or they were surprised that they qualified for as much as they did. However, it's extremely important to understand the difference between your home loan qualification amount and your overall affordability. Can you afford it?
Lenders typically qualify homebuyers based on the homebuyer's monthly recurring debt (mostly reported on the credit report) and the homebuyer's qualified GROSS monthly income (income before taxes are withdrawn). This is known as debt to income or DTI [monthly debt / monthly income]. Home loan types vary and the maximum "DTI" varies by loan type and other characteristics of the homebuyer's ability to qualify. I usually advise to try and keep the DTI under 45%.
For example: if a homebuyer earns an $85,000 annual salary, the lender will calculate $7,083 for monthly income. Let's assume that the homebuyer has an auto payment of $600, a credit card payment of $320, and a student loan payment of $250. That totals $1,170 per month in recurring payments. Finally, the lender will also need to consider how much the total mortgage payment (PITI) will be, so let's assume $2,600. In this example, the total monthly debt for this homebuyer would be $2,600 + $1,170 = $3,770. Now we have the total monthly debt ($3,770) and monthly total income ($7,083), so 3770 / 7083 = .53. This means that the total debt to income is 53%. In other words, 53% of the homebuyer's GROSS income is consumed by monthly payments. This is NOT an accurate indicator of affordability.
Two Reasons Why Basing Your Homebuying Affordability on Debt to Income is Dangerous
1. INCOME: Most lenders use GROSS income for qualification purposes. This is dangerous because GROSS income is not the same as take-home income. GROSS income is your total earnings. However, everyone has taxes and other deductions from their GROSS income, i.e. federal and state taxes, social security, medicare, etc... Sometimes the actual take-home (net pay) can be 20%+ less than the actual income earned. It's important to budget based on net pay, rather than gross pay. The sample below indicates this homebuyer's GROSS income of $1,480. After taxes and deductions, however, the homebuyer is only taking home $1,100.23. That's 25% LESS!
2. DEBT: While a credit reporting bureau may publish a homebuyer's payment history on trade lines, i.e. auto payment, credit card, mortgage, etc..., it's important for the homebuyer to also consider the monthly payments that are not reported on their credit history such as cell phone, utilities, savings, fuel, insurance, any childcare expenses, etc... Not doing this early in the home application process can result in buyer's remorse because the qualification was based on an amount if income that isn't accurate (too high) as well as an amount of debt that that isn't accurate (too low).
Factoring in all monthly expenses (including a future mortgage payment) and true take-home income may set you up for a less stressful homebuying process and a more joy-filled experience of homeownership after moving in to your new home because your budget will be one less thing to worry about. The sample below shows the difference between a DTI calculation on the left-hand side and an actual budget calculation on the right-hand side. The DTI calculation can be misinterpreted as having $3,313 left over after paying all bills. The actual budget on the right side, however, accurately reflects how much the homeowner would have left at the end of each month ($25).
This is a lot to educate yourself on and consider, but it's important to do so because your home purchase may be the single largest expense of your life.
The answer to question #6: Do I have to have a real estate agent?
After readying through my 8-part series of answers to America's most common homebuyer questions, I hope to guide you to the answer the most important question: Are you ready?
Terry Roberts is a U.S. Marine Corps Veteran and specializes in residential mortgages, including new construction, conventional, FHA, and VA home loans. he has helped more than 10,000 clients start the homebuying process across America.
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