Sun, Dec 2, 2018
First-time home buyers always want to know “How much house can I afford?” - but the real question they should be asking themselves is “How much mortgage can I afford?”
Why is this such an important distinction and why does it matter?
Well, I’ve seen it happen countless times throughout my career. You have grand visions of your dream home, after all it’s cheaper to buy than rent, right? However, when you sit down at the bank, your loan officer drags you back to reality.
Hopefully this article will help you avoid that embarrassment when you are ready to get approved for a mortgage.
When shopping for a new home, you get to pick the house, but the bank will tell you how much you can spend.
That’s because they use a few basic formulas to determine how much mortgage you can afford.
Banks typically use two Debt-to-income ratios (DTI) to determine how much they are willing to lend you. These formulas are the front-end and back-end ratios.
When you apply for a loan the bank will require proof of income. This is a key ingredient in their formula.
Most lenders agree that your monthly housing expenses should not exceed 28 percent of your gross monthly income.
According to a new U.S. Census Bureau report, the median household income is around $54,00 - or $4,500 per month.
Based on the suggested front-end ratio of 28 percent, you can spend $1,260 on your monthly housing expenses.
While this may sound like enough to buy a nice home, you also need to include all other housing related payments such as property taxes, homeowners insurance and HOA dues.
These extra payments usually add up to around 15 percent of your monthly housing expenses.
What’s included in your monthly housing payment?
Monthly Mortgage Principal and Interest Payments
Monthly Real Estate Property Taxes
Homeowners Insurance Premiums
Homeowners Association Dues
Another area that your lender will carefully look at is your total monthly debt service. This includes your monthly housing expenses plus all other outstanding monthly debt payments.
These include credit card minimum payments, car loans, installment loans, as well as child support and alimony.
**Combined with your monthly housing expenses, your monthly debt obligations should not exceed 36 percent of your gross monthly income. **
Continuing with our example above, if your monthly household income is $4,500, your total monthly debts service and housing payments should not be more than $1,620.
If you spend the full 28 percent (or $1,260) of your gross monthly income on housing, that only leaves you $360 to cover your other expenses.
As you can see the numbers start to add up fast!
What’s included in the Back-End Ratio?
Credit Cards (Minimum Monthly Payment)
Child support or alimony
After running the numbers above we determined that you can afford to pay $1,260 on your monthly housing payments if you make $4,500 per month.
So, what will $1,260 buy you? That’s a great question!
The answer depends on a number of factors such as your credit score, down payment and aversion to risk.
Mortgages are available from many different sources and in various styles:
VA Home Loan
There are many types of mortgage financing available depending on your situation:
30 Year Fixed Rate Mortgage
15 Year Fixed Rate Mortgage
Adjustable Rate Mortgage (ARM)
As you can see there is a wide variety of mortgages available. All you need is a little creativity to make one of them work for your specific situation.
Today, lenders have much higher restrictions on mortgages, so not all options may be available to you depending on your credit rating and available down payment.
While I tried to help you answer the question: “how much mortgage can I afford?” - we really just scratched the surface. Check back for more home buying tips and daily mortgage interest rate updates.
If you have any home buying or design questions, feel free to leave a comment in our home design and remodeling community on Facebook.