You're tired of renting and you've decided that you want to buy a house. The bank has told you that you qualify to buy a home for $300,000. Can you rely on this as the gospel truth? What if the furnace breaks or the roof springs a massive leak? Can you afford to fix it and make your mortgage payment, too? How can you be sure you won't get in over your head?
These are all sensible, logical questions. Many homebuyers overestimate how much they can really afford. You can realistically calculate how much home your income and budget can accommodate when you understand all the terms involved and how they affect your buying power.
- Lenders look at your front-end and back-end debt ratios to determine how much house you can afford to buy.
- Your front-end ratio is the percentage of your pre-tax income that goes toward your PITI (principal, interest, taxes, and insurance).
- Your back-end ratio compares your pre-tax income to your total monthly debt payments, including your potential PITI payment.
- You can borrow less than you’re approved for if that’s a better fit for your budget.
Front-End Debt Ratios
First, look at your monthly gross income. That's your income before taxes and things like retirement contributions are deducted. This is how much you make per month, not how much you take home. Use this number to calculate two ratios.
Lenders use what is called a front-end ratio, which is reflected as a percentage of your gross monthly income, to determine how much loan you can qualify for. The front-end ratio indicates the payment you can reasonably afford from the lender's point of view, although this isn't to say that you wouldn't prefer a lower payment.
The front-end ratio for an FHA loan is 40% as of 2020. This means that if your monthly gross income is $4,000, your monthly principal, interest, taxes, and insurance payment, called PITI, can't exceed 40% of $4,000, or $1,600.
For conventional loans, the front-end ratio isn't as important to lenders as back-end ratios—but it's good to keep in mind that you are unlikely to be approved if your front-end ratio exceeds 49%.
Back-End Debt Ratios
The back-end ratio reflects your new mortgage payment plus all your recurring debt. It, too, is computed on your gross monthly income. The back-end ratio is always higher than the front-end ratio. The back-end ratio is 43% as of 2020 for an FHA loan—but can be higher depending on your credit score. And the back-end ratio is 50% for a conventional loan.
This means that if your car payment is $300 and you pay $100 a month between two credit cards, your total monthly recurring debt is $400. Your total debt would be $1,640 including an FHA loan payment of $1,240 PITI and that $400 in recurring debt. The back-end ratio number is $1,720, or 43% of $4,000. Your total debt is less than $1,720 so you would qualify.
For a conventional loan, multiply $4,000 by 50% to arrive at $2,000. Your total debt of $400 plus your new mortgage payment of $2,000 for a conventional loan equals $2,400. That's more than the back-end ratio of $2,000, so you might not qualify for a conventional loan.
Home Sales Price Affordability
Now that you know how much of a mortgage payment you're likely to qualify for, you can figure out how that relates to the sales price. You'll hear experts say that you should pay anywhere from two to six times your annual salary, but it's smarter to look at the amount of mortgage you can get for the monthly payment you can afford.
Your mortgage amount will depend a great deal on interest rates. Interest rates fluctuate daily, sometimes hourly. Say you want to pay $1,000 per month PI. At 6% interest on a 30-year fixed-rate mortgage, you can borrow $170,000, payable at $1,019 per month.
At 7% interest, however, you can only borrow $150,000, payable at $998 per month. In this example, you lose $20,000 of borrowing power when the rate jumps from 6 to 7%.
The Down Payment
Down payment amounts depend on several factors. First, how much do you feel comfortable putting down? It's often suggested that first-time home buyers keep a healthy reserve and not dump every single cent they have into the down payment on a home.
If you qualify for 100% financing, your down payment will be zero. VA loans are available for veterans at no-money-down. Some first-time home buyer programs accept borrowers with limited funds for gift down payment programs, providing they can meet certain income limits. You won't qualify if you earn too much money.
Minimum FHA down payments are 3.5% of the sales price, so long as your FICO credit score is 580 or above, in 2020. Your sales price would be $155,440 and your down payment would be $5,440 if you borrowed $150,000. Some first-time home buyer programs help with the down payment when they're used in conjunction with FHA.
Any loan that is more than 80% of the sales price will require PMI or private mortgage insurance, and this will increase your monthly mortgage payment. Typical down payments are 5%, 10%, or 15% of the sales price. If you plan to put down 5% and borrow $150,000, your sales price would be $157,900 and your down payment would be $7,900.
Then there are closing costs. Sellers will sometimes pay some or all of a buyer's closing costs, but you can figure that they will add up to 2% to 3% of the sales price. On a sales price of $150,000, your closing costs could run about $4,500 on a sales price of $150,000, which is extra and on top of your down payment.
Your Payment Comfort Level
Before you jump into homeownership, why not set aside the additional amount you would pay for a mortgage every month to see how you do? For example, if your rent is $800 and you plan to pay $1,200 for a PITI payment, set aside $400 per month for three to six months. In other words, pretend that you're making a mortgage payment. If $1,200 a month doesn't strap you for cash, you can probably afford that much for a mortgage payment.
If you feel more comfortable borrowing less than the amount shown on your loan preapproval letter, then do so. Don't make the mistake of taking out a mortgage that will be a struggle for you to maintain. Do what feels right.
A dream home can usually wait. You probably don't need to buy the most expensive home you're qualified to buy. Consider a starter home as your first home. Work first on building equity and security for yourself and your family.