You've found your dream home in the perfect neighborhood.
There's just one problem: You do not know if you can afford the monthly mortgage payments that will come with the home.
Fortunately, there are a series of housing and debt ratios that you can use to determine whether the home you want is also one that you can afford. By studying these ratios, you'll avoid taking out a home loan that will put you in a precarious financial situation.
Housing-expense ratio
The first of these ratios is the housing-to-expense ratio, also known as the front-end ratio. This ratio will tell you how much of your gross -- or pre-tax -- monthly income is available for using for your monthly mortgage payment.
In general, you want your monthly mortgage payment -- which includes your home loan's principle, homeowner’s insurance payments, and taxes -- to take up no more than 28 percent of your monthly salary. Anything higher than that could place too much of a strain on your household finances, leading eventually even to missed housing payments and foreclosure. Simply put, you cannot afford your mortgage loan payments if they total more than 28 percent of your monthly salary.
To determine this ratio, multiply your annual salary by .28. Divide that result by 12 -- representing the 12 monthly mortgage payments you make each year. This will show you the highest housing-to-expense ratio that you can afford.
For instance, if your annual salary is $50,000, your monthly mortgage payment should total no more than $1,166.
Debt-to-income ratio
Your debt-to-income ratio, also known as your back-end ratio, is also important. This ratio tells you how much of your monthly salary is eaten up by all of your expenses, not just housing. Your expenses would include any recurring payment, such as your mortgage loan, car payment, student loan payment, credit card debt and child support.
You want your total monthly debts to account for no more than 36 percent of your monthly income.
To determine your maximum affordable debt-to-income ratio, multiply your annual salary by .36 and divide the resulting figure by 12. For that $50,000 annual salary, the maximum amount of monthly debt obligations you'd be able to afford would be $1,500. Remember, that figure includes your mortgage payment and all other monthly debts.
Loan-to-value ratio
There's one more ratio you need to know when buying a home. This one, though, determines whether mortgage lenders will approve you for a mortgage for purchasing or refinancing a home.
The loan-to-value ratio spells out exactly what percentage of a home's value you are asking to finance. When purchasing a home, most private mortgage lenders will want you to put down a down payment of at least 5 percent of a home's value. This will leave you with a loan-to-value ratio of 95 percent: You are asking the lender to finance 95 percent of your housing purchase.
If you want to eliminate the private mortgage insurance requirement that comes with mortgages with down payments less than 20 percent, you'll need a loan-to-value ratio of at least 80 percent.
If you want to refinance your home loan, you'll typically need a loan-to-value ratio of 80 percent or lower. There are programs though, some offered through the federal government, that allow owners with higher loan-to-value ratios to apply for a refinance.