How Much Home Can You Afford?
One of the most common questions a first-time home buyer will ask is “How much home can I afford?”
The answer, as a mortgage lender will tell you, is that “it depends”.
There are no concrete rules for how much home you can afford, or how big your mortgage can be.
In part, this is because mortgage lenders determine your maximum home purchase price differently from how you might calculate it yourself via a mortgage calculator.
Both methods, though, take today’s mortgage rates into account.
Let’s examine them.
Method 1: Let The Bank Use DTI To Determine Your Maximum Purchase Price
When you ask a bank to calculate your maximum home purchase price, the bank will give very little consideration to your existing home hunt, or any properties on which you’ve considered making an offer.
Rather than using a specific sales price, the bank will consider your annual income and your annual debts only.
It will use that data to find the largest mortgage payment you could make without raising your debt-to-income (DTI) ratio above allowable maximums.
Most conventional loans enforce a maximum DTI of 45%, with the exception of the HomeReady™ program, which allows up to 50% DTI.
FHA, VA, and USDA mortgage loans also enforce a maximum DTI near 45%. Jumbo mortgages stop around 40% DTI.
Now, once the bank has found your maximum mortgage payment, it uses current mortgage rates to “back in” to a loan size, which tells you how much you can borrow.
This method of determining how much home you can afford is effective, but dangerous. It’s based on borrowing the absolute maximum for which you can get approved, which is often not advisable.
Banks can’t tell you what you should pay for a home — they can only show you what you could pay for a home.
Your debt-to-income is considered in two parts — the front-end ratio and the back-end ratio.
Debt-to-Income : Front-End Ratio
The first component of the debt-to-income ratio is the “front-end ratio”.
Front-end ratio compares the expected monthly housing payment to a buyer’s monthly income, where “housing payment” includes all of the following obligations :
- Monthly principal + interest payments
- Monthly real estate taxes due
- Monthly homeowners insurance due
- Monthly dues due to an association
There is no maximum limit for a front-end ratio, but lenders prefer to see front-end DTI of 28% or less. This means that banks prefer that 28% or less of your total monthly income be allocated to your housing payments.
You can still be approved with a front-end ratio above 28%, but it’s a little less usual.
Debt-to-Income : Back-End Ratio
The second component of debt-to-income ratio is the “back-end ratio”.
Back-end ratio compares not the monthly housing payments against a buyer’s monthly income, and all other monthly payments, too.
Back-end ratio accounts for all of the following monthly obligations a home buyer may have :
- Monthly housing payment(s)
- Monthly minimum credit card payments
- Monthly child support or alimony
- Monthly car payments for a car loan or lease
- Monthly payments to an installment loan such as a timeshare
In general, banks want to see a back-end ratio of 36% or less, however, having a DTI over 36% will not disqualify your loan application automatically.
Method 2 : Make Your Own Monthly Household Budget
As a home buyer, you can rely on a bank to tell you how much home you can afford, or you can figure it out on your own.
In many cases, your bank will approve you for a more expensive home than you want to purchase. This is because banks will approve you to your maximum home price, which can generate more fees.
When you purchase at your maximum upper-limit, though, it doesn’t leave you with much cash for saving, investing or living — let alone paying taxes.
Therefore, consider a more personal approach to “How much home can I afford?”.
To do this, first, determine the maximum monthly payment you’d like to make each month. This will require thought and attention to your household budget.
Then, using using a mortgage calculator, plug in your desired payment and today’s mortgage rates to find the loan size that kind of payment will afford.
For example, if you budget for a monthly housing payment of $2,500 with two percent annually going to taxes and insurance, assuming the current 30-year mortgage rate is 4%, the math “worked backwards” reveals a maximum home purchase price of $385,000.
This method is better at holding you “on budget” as compared to letting a bank set your maximum purchase price.
Source: How Much Home Can You Afford?
Divorce Mortgage Pro Commentary:
This is an exceptional article that is spot on regarding one of the major issues in divorce lending. I see daily clients that are emotionally connected to their home, but who have not looked at whether they can afford it. This analysis should include both the guideline drive loan approval process, but also the post divorce budget. The former is necessary to see if you can even restructure the financing. Many people facing a divorce fail to consider this and end up with aspects of their divorce decrees that they cannot execute. The latter can make or break your overall post-divorce standard of living. Divorce radically impacts finances and if you begin your new start hamstrung with an excessive house payment, it can significantly impact achieving your goals.