A key question for anybody contemplating the purchase of a home is how much house can you afford?
The answer is not simple and requires the consideration of many factors. Where you are in your stage of life also greatly affects this question. Are you “first-time buyer” with little down payment funds and a young family, or are you an “empty nester” now “down-sizing” with lots of equity to apply to the purchase?
Let’s assume that you need a mortgage loan – most buyers do. What are the criteria that lenders use to evaluate your “lendability”, and the amount that you can borrow? They are as follows:
- DEBT-TO-INCOME RATIOS
These are ratios that measure your debt compared to your gross monthly income. The most used ratios are;
This ratio is your total monthly housing debt. It is calculated by adding your mortgage principal, interest, PMI insurance, home insurance and taxes and dividing this total amount by your gross monthly income. A standard rule for most lenders is that your FRONT-END-RATIO should not be more than 28%.
- BACK-END RATIO
This ratio is your total monthly debt divided by your gross monthly income. Your total debt will include your total housing debt (as above), plus any debt payments for car loans, student loans, minimum credit card payments, any child support or alimony payments, and any other debt. As example, if your total monthly debt is $3,600, and your total monthly income is $10,000, then your BACK-END RATIO is $3,600 / $10,000 = 36%. Most lenders try to limit this figure to not more than 38%.
One thing to remember is that ratios aren’t rigid. Lending decisions can be “pushed” by the lender depending on the applicant’s unique situation or credit score. Under the “qualified mortgage rule”, federal regulations give legal protection to well-documented mortgages with back-end ratios up to 43%. This rule provides protection to the lenders too.
The best path is to seek advice from a qualified local lender. He/she would be able to analyze all of your figures and life considerations to offer the best council, if not commit to the amount of mortgage that could be provided at prevailing interest rates. Click here to see lenders that I recommend in the Northern Colorado region.
- CREDIT HISTORY
An Applicant’s credit rating (FICO) is a key metric for a lender in determining how much to lend (and at what interest rate) to the borrower. A borrower with a FICO credit score of 740, or higher, generally will get a lower interest rate because they will be perceived by the lender as having less risk of defaulting on the mortgage payments.
- DOWN PAYMENT
The amount of cash that pays the remaining purchase price is the “Down Payment”. It also is the equity portion of the purchase. The EQUITY RATIO is the percentage of the equity compared to the total purchase price. A house can be purchased with as low an equity ratio of 3% under FHA insured mortgages. Most lenders would like to see a ratio of 10%. A highly desirable ratio of 20%, or more, typically will mean that the borrower will not need not carry Private Mortgage Insurance (PMI).
Another consideration for determining how much house you can afford – assuming you meet all of the criteria above – is related to your lifestyle and also to the future you see for yourself.
Regarding your lifestyle, do you anticipate that your expenses will rise significantly during your ownership of the home, so that your mortgage might become a burden? For example, do you live in areas with very cost of living? Do you anticipate children entering college and your education expenses skyrocketing? Are you covered in case anyone in your family has an extended and costly illness? All of the above, and many others are considerations.
Also, regarding your projected future, are you on a growth curve in your career, where you can expect larger income in the coming years? Or, are you anticipating retirement in future years, where your income will fall to a different level or continue to decline? These also are considerations for how much home you could/should buy?
The key consideration is that you need to project and estimate as many of your future cash flow requirements as possible, so that you will have a level of comfort that you will be able to properly service all of your housing related expenses, and also support your lifestyle.