Determining Home Affordability
“How much can I afford?” It’s one of the first questions you ask when buying a home for the first time. Even if it’s not your first rodeo, you still need to know how much you can afford if you are refinancing or buying new property. The short answer: It depends. Let’s look at the different ways to calculate home affordability.
Instead of focusing on the actual sales price, the bank will typically factor in your annual income and debts. Your bank will then find the highest mortgage you can afford without increasing your debt-to-income ratio (DTI) beyond the limit. The maximum DTI for conventional loans is 45%. Some government-backed loans like FHA and VA loans also follow a 45% maximum. After your bank calculates your maximum mortgage payment, current mortgage rates are considered to tell you how much you can borrow. One disadvantage to this approach is that your bank will only tell you how much you could afford in repayments. It will recommend the highest amounts that you could get approved for, which could be risky.
In calculating your DTI, there are two things lenders look at: the front-end and back-end ratios. What’s the difference between the two?
DTI Front-End Ratio
This component is a simple comparison between your expected monthly housing payment income versus your monthly income. Here, the monthly payment covers the following:
- Principal and interest
- Real estate taxes due
- Homeowners insurance due
- Recurring association due
Lenders ideally like to see a 28% DTI. In other words, banks prefer that 28% or less of your total monthly income be allotted for your mortgage. If you go above 28% you can still be approved but it’s not always the case.
DTI Back-End Ratio
What’s different about the back-end ratio is that it calculates not only your total monthly income and expected housing payment. It also counts your monthly recurring expenses including:
- Minimum credit card payments
- Car payments (loan or lease)
- Child support or alimony
- Student loans
Lenders prefer a 36% back-end ratio but this shouldn’t mean automatic disqualification if you go above this in your application.
Having your bank calculate your maximum payments is just one method. Another way to tell how much home you can afford is by setting your own budget.
Make Your Own Budget
You can have your bank assess and approve how much home you can afford. Typically, this means the bank will approve the highest maximum home price you can pay for. But remember that you will still have to account for living expenses, savings, and taxes. A more personal approach is to look at your income and expenses, and use a mortgage calculator to determine your desired payment. Knowing today’s mortgage rates will impact your budget. At National Home Loans, we can assist you with finding a more flexible loan based on your needs and goals.