So you have decided you want to buy a house but where should you begin? For many people, the first task is looking for the perfect home. But the first task on your list should be to figure out how much you can afford for that perfect home.
It is very disappointing to have your heart set on the home of your dreams, only to have your lender tell you that it's just that - a dream. When it comes to calculating how much you can afford, there are many avenues to obtain this information. Your lender can calculate it for you, you can find a calculator on the Internet or you can calculate it yourself.
In order to get started, you will need the following: your monthly gross income, your monthly debt payments, current mortgage rates for your market, and an idea of how much of a down payment you can afford.
One of your lender’s main concerns is whether or not you can afford the monthly payment. To determine this, they will look at your front-end ratio and your back-end ratio. These ratios, also commonly referred to as debt to income (DTI) ratios, determine the maximum monthly payment you can afford. Keep in mind that there is no set ratio. The ratio is highly dependent on your lender, the loan program, your creditworthiness and your down payment.
This ratio is calculated based only on the expenses associated with the mortgage. These expenses include your payment (principal and interest), real estate or property taxes, homeowners insurance, private mortgage insurance (PMI) and any homeowners association dues.
To calculate this ratio, divide your total payment by your gross monthly income. A commonly accepted ratio is 28%, meaning your payment cannot be more than 28% of your gross income.
For example, if you earn $36,000 annually, that is $3,000 per month. Let’s assume your total housing payment (principal and interest, taxes and insurance) is $750 based on the current market rates.
$750 / $3,000 = 25%
Based on this scenario, you would qualify for the mortgage on the front-end. But what about the other payments and obligations you have? This is where the back-end ratio is used.
The back-end ratio considers all of your long-term debt including the total mortgage payment. A commonly accepted back-end ratio is 36%. Payments that are included in this ratio include anything that will take one year or longer to pay off. This can include car payments, credit cards and other loan payments.
Let’s use the same scenario as above and assume you also have a $250 car payment along with $40 per month in minimum payments on a credit card.
($750+$250+$40) / $3,000 = 34.6%
Given these numbers, you would qualify for the mortgage on the front-end and the back-end.
Time to shop?
You now know that you can afford a total payment of $750 per month. But what does that translate into for the total cost of the house? It depends. There are still two other factors to consider – current interest rates and your down payment. Let’s look at the following scenario to see how greatly these two items can affect your price range.
| ||6% for 30 years ||7% for 30 years |
|5% down payment ||$102,500 ||$93,500 |
|10% down payment ||$107,500 ||$98,000 |
|15% down payment ||$112,000 ||$103,000 |
|20% down payment ||$127,000 ||$116,000 |
|*Amounts have been rounded |
As you can see, the interest rate and down payment can have a noticeable impact on the amount of house you can afford. With this scenario, you could look at houses between $93,500 and $127,000. It will all depend on how much you have to pay down and what current mortgage rates are.
Notice the big jump in the cost of the house between a 15% down payment and a 20% down payment? This is because PMI is no longer being paid when you put down 20% on the house.
What else does the lender consider?
Depending on the size of the down payment, your lender may also be more lenient on your ratios. For example, if you are only paying down 5%, they will more than likely be very firm with the standard ratio. But if you are paying down 20%, they may be willing to allow for a higher ratio on the front-end, back-end or both.
Your creditworthiness is also a big consideration for your lender. Your credit score and history shows how well you have kept your obligations in the past. When you have excellent credit, your lender may be willing to exceed the standard ratios. With a marginal credit history, the lender may require that you meet even stricter guidelines than the standard.
Other things to consider
Many will go out and spend the maximum that their debt ratio will allow. This can be a mistake. Remember that the ratios calculate your income based on your gross or before taxes. Also, keep in mind that the only monthly payments figured in this ratio are those long-term debt payments.
Homeowners will also have electricity, phone, cable, water and maintenance/upkeep costs, just to name a few. You should also look at how much you spend each month in other areas such as entertainment, eating out, groceries, buying personal items, trips, etc. While your lender may not look at these items in calculating your ratios, it is still important that you do.
This will tell you how much you can really afford. Don't make it so tight that an extra tank of gas or an extra dinner out, blows your budget completely. This is a long-term debt that you could potentially have with you for the next thirty years. It's important to be sure you can live with it.