Among the most common questions from a home buyer is "How much home can I afford?" The answer, however, like many things, is that "it depends".
There are no concrete rules for how much home you can afford, or how big your mortgage should be. This is because the way that a mortgage lender calculates your maximum purchase price will be different from how you would calculate it yourself.
Let's look at both approaches to home affordability.
Using DTI to Determine Maximum Purchase Price
When a mortgage lender calculates a home buyer's maximum home purchase price, it doesn't actually consider the purchase price of the home.
Rather, it looks at the buyer's expected mortgage loan size and the current mortgage rates to determine the expected monthly mortgage payment, and then compares that figure to the buyer's monthly income.
This comparison is known as the Debt-to-Income Ratio. Sometimes called DTI, the ratio has two components.
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, no more than 28% of a buyer's monthly income should be allocated to housing payments.
Debt-to-Income: Back-End Ratio
The second component of debt-to-income ratio is the "back-end ratio". Back-end ratio compares not just the monthly housing payments against a buyer's monthly income, but all monthly payments.
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 automatically disqualify your mortgage application. Many lenders allow up to 45% debt-to-income.
Make a 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. Most people will opt for the latter. This is because, in many cases, a bank will approve you for a bigger home loan that you may be otherwise comfortable paying against.
Using DTI as an example, when 45% of your gross monthly income is spent right off the top, it doesn't leave much money for saving, investing or living, let alone paying taxes.
Therefore, another approach to the "How much home can I afford" question is to determine the maximum monthly payment you'd like to make towards housing, and then working that figure backwards to find a maximum mortgage loan size.
For example, if you budget for a monthly housing payment of $2,500, and the current 30-year fixed rate mortgage rate is 4%, assuming real estate taxes and homeowners insurance cost 2 percent annually as compared to the value of the home, you work the math backwards to find that your maximum purchase price for a payment of $2,500 is $385,000.
By setting your monthly maximum payment, you can make sure to stay in budget. If you leave it to the bank, you may stretch yourself too thing.
Janus Mortgage Corporation is a mortgage broker licensed in the State of California, under the auspices of the California Bureau of Real Estate license number 02038085 and the National Mortgage License Registry NMLS Number 1690954, . All offers for loan programs are made for loans on California properties only.