If you're in the process, or have been through the process, of getting approved for a mortgage loan then I'm sure you've heard the term Debt to Income Ratio. This ratio can be found in two different ways; Your way and the banks way. I recommend your way instead of the banks because you can easily see what you can afford for a monthly mortgage payment. When figuring out this number make sure you remember taxes, insurance and new house expenses.
The Banks Formula (Not recommended)
The reason I don't recommend this formula is simple, you know your bills better than the bank does! The bank doesn't want to have to ask you for every monthly bill to your name, so they only incorporate any loans or major bills you have into the Interest Calculator (Auto loans, College loans, Mortgages, Taxes, Insurance and Condo Fees). The bank already accounts for your monthly home expenses such as heat, electric, cable, phone etc.). You show the bank your last two years of W2 statements which shows your gross income per year. They take the average, and cut it in half. If your monthly bills equal that amount then your debt to income ratio is exactly 50%. I don't think anyone will get a mortgage loan using more than 50% of their monthly gross income. Example below:
Income 2008 = $60,000.00
Available Monthly - 60,000 / 12 months = $5,000.00
Monthly bills:
Mortgage $950.00
Taxes $350.00
Insurance $50.00
Condo Fee $200.00
Auto Loan $250.00
Total: $1,800.00
Now divide 1800 / 5000 = .36 = 36% Debt to Income Ratio. Right now, in the tough economic times, banks aren't allowing much over 40%. During good times they were allowing up to 50% before a caution mortgage loan. Remember to include the new mortgage you're trying to get into your debt to income ratio. Some banks will approve your mortgage loan for much more than you think you can afford, DON'T fall for this. Yes, you might be able to get into a bigger house, but you won't be happy when you see that monthly payment every month and realize it really is too much.
I'm sure you can see that it's a bit confusing, so here's the method I recommend. You add up ALL your monthly bills and the new mortgage, taxes and insurance and weigh it against your net monthly income. It's the easiest, most basic, way to figure out what YOU can afford. Make sure you account for savings, or at least some extra spending money as well. Living check to check is very dangerous and will probably hurt you in the long run.
I also recommend using the different mortgage calculators I have listed all over my website. They will help you understand the mortgage process from different angles and give you a much better idea of what you can afford. Also take a look at the current interest rates (ARM rates and Fixed Rates) to get the lowest possible monthly mortgage payment. I explain the difference and reason for ARM loans, Fixed loans and Interest only loans. They each have advantages and usually aren't used in the correct way, so I'll let you know when each loan will benifit you the best.
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