Before buying a home, you need to know how much you can afford. You may have the perfect number in your head, but does the lender agree? Knowing what you can afford before you look at homes saves time and frustration.
Use the simple steps below to see how much home you can afford.
Know Your Monthly Debts
Chances are you have debts now. They won’t disappear just because you buy a home. Credit cards, installment loans, and student loans are a few examples. Lenders use these payments to calculate your total debt ratio.
Don’t worry, lenders don’t include utility bills, grocery spending, or insurance payments. They only consider the payments on your credit report.
If you notice you have too many debts, consider paying them down now. The fewer monthly debts you have, the easier it is to qualify for a mortgage.
Know Your Gross Monthly Income
Lenders look at your income before taxes. Do you earn an annual salary? Divide it by 12 – that’s your gross monthly income. You need this number to figure out your debt ratios. Lenders have different debt ratio requirements for each program.
If you work hourly or on commission, use your year-end W-2s to figure out your gross monthly income. Divide the annual income by 12. This gives you an average over the course of the year. This is important, especially with variable income.
Know Your Front-End Ratio
Lenders use your gross monthly income to determine an affordable mortgage payment. Each loan program has its own guidelines, for example:
- Conventional loans – 28% housing ratio
- FHA loans – 31% housing ratio
- USDA loans – 29% housing ratio
Once you know your gross monthly income multiply it by the appropriate front-end percentage. For example, if you make $5,000 per month, your maximum mortgage payment on a conventional loan is $1,400 and $1,550 for an FHA loan.
Use these numbers as a guide. Your total mortgage payment can’t exceed these amounts. Your total mortgage payment includes:
- Real estate taxes
- Homeowners insurance
- Mortgage insurance (if applicable)
- Calculate your Back-End Ratio
Your back-end or total debt ratio could reduce how much mortgage you can afford. This is where your total monthly debts affect things. Your back-end ratio is the maximum amount of your gross monthly income you can commit to your monthly obligations. This includes the new mortgage.
The back-end ratios are as follows:
- Conventional loans – 36%
- FHA loans – 41%
- USDA loans – 41%
- VA loans – 41%
Calculate your back-end ratio by adding up the new mortgage payment with your current monthly debts. Next, you should figure out your max total debt ratio. Do this by multiplying your gross monthly income by the appropriate percentage.
Using the $5,000 monthly income, you could have maximum debts of $1,800 for a conventional loan and $2,050 for government loans. If you want a $1,400 conventional mortgage payment, your other debts can’t be more than $400.
Does your income and debts fit this requirement?
Put the Number Into Your Budget
Thus far you have a fictitious number. Sure, it looks good on paper to have a $1,400 mortgage payment, but does it fit into your budget?
If you use a computer program or app to keep track of your budget, toss that $1,400 payment in there. How does your bottom line look? Do you still have money for your ‘other expenses?’ Can you still live the life you’re used to? Do you need to sacrifice? Are you willing to sacrifice?
If you don’t use a program or app, physically take $1,400 out of your bank account. What’s left? Can you cover your other bills? Do you have the cash to do the other things you want to do? Try this for a few months and see how it feels. Practicing before you own the home is a lot less risky than taking a chance on late payments and foreclosed homes.
Knowing how much mortgage you can afford before you shop for a home helps avoid delays. You can shop for a home within your budget. If you have the necessary qualifications for the loan, you’ll have fewer issues getting approved.