What Can You Afford?
Going to your financial institution or a mortgage broker to be pre-approved is an important step in the home buying process. Taking the time to get pre-approved will give you the security of knowing how much you can afford to spend, and ensure you are looking at homes in the right price range.
Another important reason to get pre-approved is that the institution will usually give you a 60-day rate guarantee. This is a win-win situation for you the buyer because if rates increase, you have a guaranteed rate, and if rates decrease, the lender will apply the lower rate.
How Do Lenders Decide How Much You Can Borrow?
Lenders use two constraints in deciding how much money they will lend. They calculate your debt service ratio, and the lending value for your home. The lower value of these two constraints will be applied.
Debt Service Ratio
Most institutions will use a 30% debt service ratio when deciding what mortgage payments you can reasonably afford. This means that your total monthly payments plus estimated property taxes should not amount to more than 30% of your gross income.
If you have other payments such as a vehicle loan or credit cards, the lender will take these into account and a Total Debt Service Ratio will apply. This ratio generally used is 40%.
Lending Value Constraint
When you do find the home you want and put forward the offer subject to financing, the lending institution will usually require an appraisal be done. The purpose of the appraisal is to find a lending value for your home financing. This, along with the Debt Service Ratio, will form the lending constraints for your loan, ultimately effecting its final size.
Other assets or investments will also affect financing, as well as the amount of your down payment.