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Home Purchase Planning

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The Debt-to-Income Ratio

When you apply for a mortgage, lenders compare your pre-tax income to your housing costs and other debt payments. Known as the "debt-to-income ratio," this figure helps lenders determine how much money you can afford to spend on monthly mortgage payments.

The debt-to-income ratio also governs how much you can borrow to buy a house. In general, most lenders prefer that all debts, including housing costs, should total no more than 36% of income. The debt-to-income ratio allowed by lenders can vary, however, especially if you're able to make a down payment of 20% or more and have little additional debt.

But the ability to qualify for a certain loan doesn't always mean that you can afford the loan. You may have heard the term "house poor" before - meaning your home ownership expenses leave you with little cash for anything else. Remember, the debt-to-income ratio just measures income and debt. It doesn't consider your spending habits or non-debt expenses like health insurance or childcare. Especially when buying your first home, it can be a good idea to consult with a financial professional - one who places your overall financial interests first.

Saving for a Home Purchase

When buying a home, there are upfront costs you'll need to consider. Costs can include:

  • A down payment of at least 5% - 20% of the purchase price.
  • A loan origination fee.
  • Legal fees.
  • An escrow deposit (money deposited with your home offer).
  • Cash reserves of at least two months of principal, interest, taxes and insurance (PITI) payments, depending on your lender.
  • Inspection, appraisal and title search fees.
  • Moving costs.
  • Utility deposits.

The largest cost is likely to be the down payment, a payment that's applied directly to the cost of your home. Unless you qualify for a special lending program, down payments typically range between 5% and 20% of the cost of the home. In addition to reducing the cost of your mortgage, a large down payment can also eliminate the need to purchase private mortgage insurance (PMI), a type of insurance policy that's required of borrowers with less than 20% equity in their home. Depending on the amount borrowed, avoiding PMI could save hundreds, if not thousands, of dollars per year.

To estimate the minimum you should save for a down payment, it's helpful to get an idea of how much you can afford to spend on a home. A rule of thumb is that the cost of your home should be somewhere between two and three times your annual income. For example, a person with an annual income of $100,000 may want to consider finding a home that costs between $200,000 and $300,000. In expensive metropolitan areas, it's sometimes necessary to spend even more. Like the debt-to-income ratio, any rule of thumb about home affordability can't account for your specific situation, so you'll always want to run your budget numbers before making a decision. Will you have enough to cover your expenses plus any home repairs? Will you have enough money to make it through a period of unexpected unemployment? 

Excluding your down payment, other costs associated with buying a home can total between 2% and 5% of the home's price. Some of these costs, however, can be included in your mortgage. These are just some things to keep in mind while you begin to shop for your new home!