Buying a house: This is the Single Most Important Thing You Need To Consider

Everybody wants to own their own home. It’s the American dream. If you want to own your own home there’s one number — one ratio — that you must satisfy. It’s a number which will make lenders happy to work with you.

Since most of us don’t have the cash to plunk down to buy a house, we all need to get a mortgage. Your ability to secure a home loan is primarily predicated on that one number, which is the Debt-to-income ratio.

They important number here is 36%. If your debt-to-income ratio is 36% or less, you have satisfied one of the key ratios that lenders look at when considering you for a mortgage. Determining you debt-to-income ratio is relatively easy. it’s basically your your monthly expenses divided by your monthly income. For instance, if your total income each month is $5,000 and your expenses are $1,000, then your debt-to-income ratio would be 20% ($1,000 / $5,000 = 0.2 or 20%.)

Lenders would be very happy to entertain a potential client with a 20% debt-to-income ratio. Provided that the borrower had the necessary down-payment for the house, a reasonably good credit score, and a steady income, most lenders would likely be eager to loan money to a borrower with this ratio. With such a low debt-to-income ratio, many lenders would probably suggest that you could borrow even more money. Remember, 36% is the magic number, if your debt-to-income ratio is no higher than 36%, lenders would be interested in entertaining you are a client. With a debt-to-income ratio of just 20%, lenders would feel that there is an opportunity to loan you even more than you are asking for. It’s easy to see how much debt you can manage; a level which lenders would be comfortable with. Take your monthly income and multiply that by 36%. That will give you the total debt level which would probably be acceptable to most lenders. Using that same example of a monthly income of $5,000, lenders would likely be okay with a cumulative debt level of $1,800 ($5,000 * 36% = $1,800.)

That $1,800 is not just your mortgage. it is the combination of all of your debt. This includes costs related to your home like property taxes, home owners insurance, and PMI or Private Mortgage Insurance. (Most lenders require PMI when you borrow more than 80% of the value of your home.) Your overall debt is not limited to your real estate related debt, it includes all debt, including car loans, student loans, credit card debt, etc. Your income is not limited to your monthly wages, it includes all of your income, including child support, alimony, etc.

Once you have added up all of your debt, and compared it to your monthly income, you can easily determine whether you have a debt-to-income level that is acceptable. That calculation is only easy once you know how much you will be spending on your new home. There are three or four primary factors which impact your mortgage debt:

  1. Price of the home – how much will you actually have to pay for your house
  2. Down payment – how much of that purchase price are you going to put up as your down payment. Lenders are typically looking for 20% here.
  3. Interest rate – the interest rate that the lender will charge you for your mortgage has a huge impact on your debt.
  4. Term – most people select a fixed rate 30-year mortgage, while some choose a 15-year mortgage to pay off the loan more quickly, but this means higher monthly payments.

All of these factors play a large role in determining your monthly debt. Assuming a 20% down payment on a $300,000 home purchase would mean that you would have to come up with $60,000 as a down payment. The remaining $240,000 would need to be financed. If you were able to obtain a 30-year loan with a fixed interest rate of 4.00%, your monthly mortgage payment (before taxes and insurance) would be about $1,146. If you were able to get a 15-year loan with an interest rate of 3.00%, your monthly payment would be about $1,657. In this example, the 15-year mortgage would cost about $500 more each month, but you would have the loan paid off in half the time. Whichever loan you choose would likely be your largest monthly expense in your debt-to-income calculation.

I have created a spreadsheet to help you figure out your debt-to-income ratio. You can download this spreadsheet from The spreadsheet is pretty self-explanatory. You enter your income, your debt, and the data about your home (purchase price, down payment, mortgage information, etc.) and it calculates your debt-to-income percentage. While the primary purpose of this spreadsheet is to help you quickly determine whether or not your debt-to-income ratio is at or below 36% — an acceptable level for most home mortgage lenders — the spreadsheet also allows you to run scenarios of home prices.

When you are thinking about buying a home, you might not have a good sense as to how much home you can afford. Once you enter all of your income and other debt information, you can enter varying purchase price and down payment combinations to see what impact each price has on your debt-to-income.

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