How much home can I afford? It’s a funny question. Unlike buying a measured amount of rice at the market or a length of chain at Home Depot, home-buying doesn’t lend itself to measure-and-cut precision. You can specify an exact amount of lumber, glass, and carpet. You can specify bedrooms and baths. But 3BR, 2BA home in one neighborhood may be half the price of a similar home elsewhere in town.
What you can do—and must do, if you borrow from a conventional lender—is determine the maximum amount of money you’ll be able to borrow. That, combined with your down payment, will determine the highest home value you’ll be able to handle.
Lenders will look at your income compared to your debt (“debt to income ratios”). There are two ratios that are important, the front-end ratio and the backend ratio. The front end ratio is your income compared to your mortgage payment. The back-end ratio is your income compared to your total debt, that is, your mortgage, automobile payments, student loans, and other debt. Conventional loans generally use a 28/36 ratio, that is, your mortgage payment should not exceed 28% of your monthly income and your total monthly debt should not exceed 36% of your monthly income. FHA loans use a 31/43 ratio. If you get lost in the math, a good rule of thumb is that your total gross monthly income should be about three times your total monthly debt to qualify for a loan.
The best way to take into account your entire financial picture is to use one of the many good mortgage calculators available online. You can find a good home-affordability mortgage rate calculator at Trulia.
Like all good, sensible things, the limits on borrow-ability have been pushed and abused. Particularly during the real estate boom ending around 2005, some lenders would approve home loans based on ratios beyond 30 and even 40 percent. That’s how so many people got in over their heads and lost their homes.
Other factors, beyond the scope of this article, will influence loan affordability big time. Adjustable Rate Mortgages, for example, usually offer lower payments in the early years, followed by a bump upward later. ARMs represent another good idea that has been frequently abused in the recent past.
Your max loan amount is one thing. The highest home purchase amount is another. How much cash will you need to put down? That’s for your lender to decide, and it’s wise to talk to several lenders—or visit a finance site such as LendingTree.com. The answer depends on many factors. Some lenders may demand a full 20 percent down. If so, that 233,000 loan amount would have to be accompanied by more than $58,000 in cash, just to purchase a $291,000 home. It may sound scary, but prevailing standards vary a lot—between banks and with the times. Extraneous factors such as federal tax credits have at times reduced down payment demands for some borrowers to as little as 3.5 percent, and have offered $8,000 of down payment assistance
This approach to the affordability question began with your income, and adjusted for personal life circumstances such as other debts. Another way is to start with the home value and work backwards. If the price is $300,000, what sort of down payment will I need? What size loan will make the deal possible? How much income will I need to service that debt?
[This article originally appeared on Trulia.com and has been republished with permission.]