Preparing to Buy a Home: How Much House Can You Afford?
There is a right way and a wrong way to buy a home. People who do it the wrong way head out to open houses on the weekend or jump on real estate websites after work, see a place they like and go straight to making an offer. Without knowing what it would cost them every month or how it would affect their budget.
The Right Way to Buy a Home
Here’s the right way to buy a home:
- Figure out what you can afford to spend each month.
- Determine the size of your down payment and where you’ll get it.
- Save your down payment if needed.
- Improve your finances and/or credit score if necessary.
- If buying will raise your monthly housing costs, get used to living on less money.
- Prequalify for a mortgage.
- Apply for mortgage preapproval.
- Find a home and make your offer.
There should be no ugly surprises when you buy your house. You should be very clear on the costs and how it will affect your budget.
How Much Home Can You Afford?
How do you determine what’s affordable for you when you buy a home?
You could use a general rule, work with a mortgage calculator, ask a loan officer, or submit an application to a mortgage underwriter. However, the highest authority may be your own gut. Here’s why.
Common rule of thumb
Everyone likes a rule of thumb because it’s easy. You don’t have to be a math genius or (gasp) create a budget. One popular rule says you can borrow three times your annual gross income to buy a home. So, if you earn $75,000 per year, you can safely borrow three times that — $225,000.
There are two HUGE flaws in this logic. First, it doesn’t account for mortgage rates. A $225,000 loan with a 4% interest rate has a principal and interest (P and I) payment of $1,074. But for the same loan amount at an 6% interest rate, the P and I payment is $1,350.
You can’t compute an affordable loan amount without considering the interest rate, mortgage insurance, and loan term.
Second, the rule ignores your other expenses. If you’re financing a boat, RV and college tuition, you may have less income available to pay a mortgage. And what’s affordable also depends on insurance costs and property tax rates in your area.
Mortgage calculators use debt-to-income (DTI) ratios to come up with your maximum loan amount. Your DTI equals your proposed mortgage payment plus monthly payments for your student loans, credit cards, and other accounts (but not utilities or living expenses) divided by your gross (before-tax) monthly income. Lender also call the DTI your “back-end” or “bottom” ratio.
Most lenders also consider an additional ratio — the “front-end” or “top” ratio. This number is just your proposed housing payment divided by your gross monthly income.
Mortgage calculators frequently set this number at a maximum of 36 to 43 percent. If a lender says you have an ugly back-end, it means your expenses are too high and not that the underwriter is criticizing the fit of your pants!
This calculation has limits as well. First, it does not consider your credit rating. Applicants with better credit get approved with higher DTIs than those with poorer credit. It doesn’t consider payment shock. “Payment shock” is the extent that your new house payment exceeds your current one. If your rent right now is $1,000 per month, but your new mortgage, property taxes and insurance costs are $2,000 per month, you’re looking at 200% payment shock. It’s not uncommon for lenders to allow payment shock of no more than 150%, especially with a low down payment.
Automated underwriting systems (AUS) underwrite most mortgage applications in the US. They look at your income, assets and credit report and apply formulas. Then they spit out an underwriting decision. Once you have an approval through AUS, all you need to do is submit documents proving that the information on your loan application is correct. Assuming that the property you choose meets the lender’s guidelines, you should be able to close your loan and purchase your property.
This is a much more accurate way to see how much you can afford to spend on a house. However, you’ll have to provide your information and proof of income and assets to get it. In addition, AUS does not process information like your job stability or the strength of your industry. It can’t handle incorrect information on your credit report and it can’t tell if bad credit was caused by you or something that was not your fault.
Human underwriters can deal with things that software cannot. They can adjust your maximum loan amount up or down according to guidelines. Here are some factors only humans can see that may get you a bigger loan:
- Your future income will increase a lot (maybe you just graduated from medical school).
- You have a part-time job or your spouse plans to get a new job but that income doesn’t officially count.
- You’re buying an energy-efficient house.
These factors could lower your loan amount:
- You’re renting from your Mom and can’t prove that you paid her.
- You change jobs frequently and your earnings don’t increase.
- Your bank statements show bounced checks.
Human underwriters can consider intangibles that software cannot. That may work for you or against you.
Only you know how well a new house payment might fit into your life. On paper, you may qualify for a lot more or a lot less than you could safely spend on a house. And there are some factors even human underwriters don’t consider.
Only you know if you’re planning to start a business, send a child off to college, or kick grown children out of your house. Or that you skydive, donate large amounts to charity, are planning a trip around the
world, or that you have a gambling or shopping habit that’s not exactly under control.
So when determining what you can afford, envision your life in one, five, or ten years. Plan for your goals and the money you’ll need to meet them. Decide what payment amount works for you and then use a mortgage calculator to determine the loan amount you get for that payment.
And remember — rules of thumb are great, but only if you’re buying thumbs.
Your Mortgage Payment: PITI
Home Affordability Worksheet (Calculator)
Practicing for Homeownership
Saving a Down Payment
Improving Your Credit