How Much Home Can You REALLY Afford?
When people are thinking about buying a home, they may often search for homes first without considering how much home they can actually afford. That’s not necessarily right or wrong, but my goal is for you to be as informed as possible. So, I will distinguish the difference between how much you can afford and the amount for which you may be approved.
First, let’s talk affordability. Only you know how much you can truly afford based upon your personal budget. Many personal finance experts would encourage you to budget no more than 25% of your monthly net income towards your monthly housing payment. How you break down your budget is ultimately up to you. But if you keep reading, you may find there is a difference between what you can personally afford and the amount of your approval. There are a number of reasons for this, including your other monthly payments, your loan type, and all of your income may not be eligible to be included.
When you apply, a lender will run your credit report to determine your eligibility. Then, they will calculate your mortgage-to-income ratio and your debt-to-income ratio.
The required mortgage-to-income ratio, aka front-end ratio, is the maximum portion of your income that can contribute to a mortgage payment. That ratio typically falls between 28-30% of your gross monthly income.
Mortgage to Income Ratio = Mortgage Payment / Gross Monthly Income
Example: Your monthly income before taxes is $3,870 (figure taken from the census median income statistics for Indianapolis). 28% of that is $1,083.60. So that means the max monthly payment allowable in this scenario is $1,083.60, including principal, interest, property taxes, homeowner’s insurance, and HOA dues. Depending on the property you’re interested in, the purchase price can vary WIDELY depending on the property taxes, whether the property requires flood insurance, if there is an HOA present.. etc.
Debt to Income Ratio = Total Debt Obligations / Gross Monthly Income
Next, we need to calculate your back-end ratio aka debt-to-income ratio, or DTI. The reason lenders do that is because they must ensure that you can afford your monthly payment among your other obligations. A conservative back end ratio is 45%.
Example: using the $3,870 monthly income above, 45% of your gross pay is $1,741.50. Subtract your $1,083.60 mortgage payment, that leaves $657.90 per month for other credit obligations like car payments, installment loans, student loans, and credit card payments.
If those obligations exceed the remaining balance, subtract that amount from the example mortgage payment to keep your debt to income ratio capped at 45%.
**If your other obligations come to $900 per month, now your max mortgage payment is $841.50 because you can’t exceed $1,741.50 in total debt payments per month.
If you aren’t totally confused yet and are still reading, go grab yourself a treat for making it this far!
Now, let’s add a layer and clarify how income is calculated. If your main source of income is a full-time job, this will be simple for you. The lender will average your last 2 years of income tax returns to confirm your monthly income. If you receive bonuses or overtime pay, it must be reflected over the past 2 years or only your base pay will be considered.
For the side-hustlers out there, if you have income from a part time job, you must have 2 years of documentation for that income as well for it to be factored into your debt ratio equation.
If you are self-employed or have a side business in addition to your job, you must have 2 years of profit/loss statements (Schedule C) for the income to be considered.
It’s important to note that loan programs vary and the ratios above could be different for you, based on your loan type and credit score. I used pretty modest figures in my example scenario above just to introduce you to the concepts. I fully acknowledge that this stuff can be about as clear as mud, which is why it is encouraged that you discuss your specific scenario with a trusted lender. There is no “one-size-fits-all” scenario due to the amount of factors that play a part in the calculations.
PS – student loan obligations are calculated differently depending on the loan type and that could impact your overall approval amount.
Definitions to note:
Front-end ratio – aka mortgage-to-income ratio; indicates what portion of an individual’s income is allocated to the total mortgage payment; calculated by dividing the anticipated monthly mortgage payment by the gross monthly income
Back-end ratio – aka debt-to-income ratio; a ratio that indicates what portion of an individual’s income goes towards paying debts; calculated by dividing total debts by the gross monthly income
Gross Income – Total pay before taxes and other deductions
Net Income – Total pay less taxes and other deductions, also known as “take home pay”
Mortgage Payment – aka principal, interest, taxes, and insurance or PITI; The sum of your total mortgage payment including the amounts for the principal & interest of the loan and escrow payments towards property taxes, applicable homeowner’s, flood, or mortgage insurance and HOA dues