A great way to determine the affordability of a home is by using an online calculator to estimate the payments. This tool is a great first step! After you plug your numbers in, it is time to check in with a hired professional who can help you wade through the pricing process, especially in the difficult early stages of house hunting. These are some things to consider when figuring out your home shopping budget.
The 28/36 Rule
The 28/36 rule is one way that lenders assess how much of a mortgage you can handle. First, let's talk about the front-end ratio. This rule states that your mortgage payment, including property taxes and homeowners insurance, should not exceed twenty-eight percent of your pre-tax income. Your debt, including your mortgage and other obligations like a car or student loan payments, should be no more than thirty-six percent of your pre-tax income. This number is called the "back-end ratio." These numbers are general because there are some cases where you may be able to have a higher mortgage.
According to the thirty-six percent rule, if you earn $2,500 per month, you can afford approximately $900 in total monthly payments. Some lenders may make an exception by allowing borrowers with a higher credit score to have a slightly higher debt-to-income ratio than what the 28/36 rule states. FHA loans, for example, allow a DTI of forty-three percent or higher.
What is DTI?
A DTI, or debt-to-income ratio, is the ratio of your total monthly debts to your monthly pre-taxed income. Depending on your lending resource, you may be qualified for a higher rate, closer to forty-three percent. However, it is not a good idea to exceed thirty-six percent for you to maintain that safety cushion.
Key Factors in Determining Affordability
Determining how much you can afford is a multi-layered process that requires gathering and evaluating a bundle of information:
This is the money you receive on a regular basis, such as salary or income from side hustles and investments. Your monthly income will establish the baseline of what you can afford every month.
This is the amount of cash you have available for a down payment and to cover closing costs. This can come from savings, investments, or other sources--it just has to be accessible. Keep in mind how important a down payment is in determining the loan. The larger the down payment, the more likely you will need to take on a smaller mortgage and can afford to buy a higher-priced house if that is what you are after.
Debt and Monthly Expenses
Do not forget about your current financial obligations before you tackle new ones. Everything from student loans and insurance to groceries and utilities falls under this category. Make sure you are generous when figuring the golden number that makes up your monthly expenses, leaving wiggle room for unexpected items that always pop up.
Your credit score coupled with the number of debt shapes who you are as a borrower in the eyes of a lender. That is a lot of pressure! Those factors not only help determine how much money you can borrow but also what interest rate you will owe. If you have a good credit history, you are likely to get a lower interest rate, which means you could handle a bigger loan. The best rates tend to go to borrowers with a credit score of 740 or higher, but others are still well in the game.
During this process, a lender will assess your finances to determine how much money they are willing to lend you. You can take this number with you on your house hunt to help you shop within your means. Remember, just because you qualify for a specific amount does not mean that you should go for it, or that you can even afford it. The pre-qualification process typically takes your income and debts into account, but there is no way for the result also to include your personal saving goals or spending habits. So while this assessment is super helpful, you ultimately have the final say in what you’re comfortable spending while you’re searching for your next home.
Consider Other Factors
Lenders want to know more than just your income, debt and down payment information when it comes down to giving you the significant number. The interest rate on your mortgage is enormous. The lower the interest rate, the lower the mortgage. The lower the mortgage, the more home you can afford. While it all may seem smooth sailing now, it is a good rule of thumb to have a minimum of three months of your housing payments and monthly expenses, in savings--completely untouched! This buffer will help you make a few mortgage payments in case there are some unexpected events or emergencies.
Not everyone will qualify, but it's worth a shot to look into the various state government programs that provide certain concessions to first-time homebuyers. There are other programs that you might qualify for based on your income and occupation. Do some research to see what types of assistance are out there. So don't let something that you find pass you by!
Should You Go For It?
When the bank evaluates your affordability, it only takes into account your outstanding debts. They can not read mind and do not have a crystal ball to look into your future. Lenders won’t factor in the $300 you want to save every month for retirement, or that cash you’re putting aside to finish some renovation projects. They only see additional funds for a more expensive house. So the bottom line comes down to what you want. At this point, there is not a right or wrong answer, only a preference.
However, the best advice you can have is to be careful. It is always wise to give yourself room to breathe financially over a house you can just barely afford.
When you need advice about what you can afford, come to Clever. We’re here to help! Clever uses top local real estate agents to lighten your load and help you save money. These flat-fee agents have no motivation to push buyers into a fast sale, just to make commission. Call us today at 1-833-2-CLEVER or fill out our online form to get started.