How Much Home Can You Afford?
Among the most common questions from a home buyer is “How much home can I afford?” The answer, not surprisingly, is “it depends”.
There are no concrete rules for how much home you can afford, or how big your mortgage should be. In part, this is mortgage lenders will calculate your maximum home purchase price differently from how you might calculate it yourself.
There are two approaches to home affordability and each consider today’s mortgage rates— let’s examine both.
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 home for its calculations (or a specific sales price), the bank will consider your annual income and your annual debts, then calculate the maximum-sized mortgage payment which could be added without raising your debt-to-income (DTI) ratio above allowable limits.
Once the banks has found your maximum approvable mortgage payment, it will use today’s mortgage rates to “back in” to the maximum allowable loan size.
This method is based on maximizing your debt-to-income ratio, which may not be advisable. However, the DTI-based formula is not meant to show what you should pay for a home — it’s only meant to show you what you could pay for a home.
Banks will check your debt-to-income ratio 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. In other words, banks prefer that 28% or less of your total monthly income allocate to your housing payments.
You can still be approved with a front-end ratio greater than 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. Many lenders allow up to 45% debt-to-income.
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 your maximum home purchase price 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 using a 45% debt-to-income ratio.
When you spend 45% of your income monthly, it doesn’t leave much cash for saving, investing or living, let alone paying taxes.
Therefore, consider the other approach to the “How much home can I afford” question. Determine the maximum monthly payment you’d like to make each month, and then, using today’s mortgage rates, work that figure backward to find your maximum mortgage loan size.
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 can be far more effective to keeping within a budget as compared to letting the bank set your price.