It makes sense, too, as this is a pretty significant concern. Ensuring that you can not only qualify for a certain level of mortgage but then continue making those payments for as many as 30 years is a tall order. Luckily, we have a few tips for calculating your own mortgage sweet spot.
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Needs vs Wants
If you’re considering buying a home, it helps to have an idea of how much you can afford. This will tell you the dollar amount that you need to stay below in order to make a financially wise home-buying decision.
It’s very important to think of this question from two different perspectives, though.
The first is simply: for how high of a mortgage will you qualify? The answer to this question depends on a lot of factors. Some of these factors include your income, existing debts, interest rates, credit history, and your credit score.
(In a moment, we’ll look at several calculations that most lenders use to evaluate mortgage applicants. That way, you can narrow this answer down a bit before you even begin the application process.)
The second perspective is a bit more subjective: how much home do you really need? Just because you can qualify for a mortgage, doesn’t mean that you should.
Banks will qualify you for as much as they possibly can, given their existing underwriting policies. But just because the money is available doesn’t mean you should take it. This is where you need to rein in your wants, in order to make a smart mortgage decision.
Here’s a fantastic resource for you to use – a calculator that takes into account your city, debt, income and downpayment and automatically tells you how much house you can afford.
If you want to do the calculation manually, let’s look at five ways to calculate how much house you can afford, beginning with a standard rule of thumb.
This was the basic rule of thumb for many years. Simply take your gross income and multiply it by 2.5 or 3, to get the maximum value of the home you can afford. For somebody making $100,000 a year, the maximum purchase price on a new home should be somewhere between $250,000 and $300,000.
Keep in mind that this is a very general rule of thumb, and there are several factors that will influence the results. For example, the lower the interest rate you can obtain, the higher the home value you can afford on the same income.
This is one reason why your credit score is so important. A good credit score of 760 or higher could net you an interest rate that is 1.5% lower than if you had a fair score of, say, 620. A 1.5% lower rate can easily translate into savings of tens of thousands of dollars over the life of a mortgage.
If you don’t know your credit score, you can get your FICO score for free from one of several credit scoring companies.
Also keep in mind that others may suggest using higher or lower multiples to determine your ideal home purchase price. I’ve seen banks recommend ratios as low as 1.5 times your salary or as high as 5 times your salary. I think that for most situations, a good starting point is 2.5 times your income.
When banks evaluate your home loan application, they will look at one very important calculation in particular. This is known as your housing-expense-to-income ratio.
Also called the front-end ratio, banks will take your projected housing expenses for the home you want to buy and divide by your total monthly income. Generally, mortgage companies are looking for a ratio of 28% or less.
For example, let’s say that your income is $10,000 a month. Judging by this, most banks would qualify you for a loan (subject to other factors, of course), so long as your total housing expenses do not exceed $2,800 each month. This means that your mortgage payment (principal and interest), property taxes, PMI (if required), and homeowner’s insurance all need to stay below this threshold.
While the 28% mortgage-to-income ratio is followed by many institutions, some will qualify a borrower with a slightly higher ratio. Again, it all depends on the lender, your credit history, and other individual factors.
Even if your housing-expense-to-income ratio is 28% or less, you still have one more hurdle to clear: the debt-to-income ratio.
Also referred to as the back-end ratio, this takes into account your total monthly minimum debt payments and then divides them by your gross income. This ratio is used in conjunction with the front-end ratio above, to give lenders a holistic view of your financial situation. With these two in mind, they’ll be able to make a clearer determination as to whether or not you’ll be approved for your requested mortgage loan.
All sorts of debt payments are taken into account for the back-end ratio. These include not only your projected mortgage, but also minimum credit card payments, auto loans, student loans, and any other payments on debt. Even child support payments are included.
Bankers typically are looking for a back-end ratio of no more than 36%, although some will go a bit higher than this. To relate both the 28% front-end and 36% back-end numbers, here is a chart showing the calculations for various income levels:
|Gross Income||28% of Monthly Gross Income||36% of Monthly Gross Income|
An FHA mortgage has special rules set by the government. This means there is less “wiggle room” when qualifying for these loans versus conventional mortgage products.
For the mortgage payment expense-to-income ratio (front-end), the percentage cannot be greater than 29%. Since this is the government we’re talking about, you won’t be able to sweet talk your way into getting that waived for an extra percentage point or two, either. For the back-end ratio, the maximum to still qualify for an FHA loan tops out at 41%.
Note that although FHA loans are government-sponsored, you will still apply for the loans through private banks and mortgage companies. If you’d like to get see current rates, check out our mortgage rates, which are updated daily.
Dave Ramsey takes a very conservative approach to home-buying. If you can swing it, he believes you should pay cash for a home. Of course, this is a tall order for many people who struggle to just save up enough for the down payment.
If you do have to take out a mortgage, Ramsey says you should finance your home with a 15-year mortgage (rather than a 30-year). He also says that your mortgage payments, including insurance and taxes, should be no more than 25% of your take-home pay. Lastly, he believes that you should not buy a home until you have at least a 20% down payment.
If you decide to follow Dave’s approach, simply divide the amount of down payment you have available by .20. For example, if you have $25,000 saved for a down payment, the maximum amount you could spend on a home would be $125,000 ($25,000 / .20).
Using this example, you’d finance $100,000 with a 15-year mortgage through your lender of choice. At prevailing rates, and making some assumptions about insurance and taxes, the monthly payment would be somewhere in the vicinity of $1,000.
Of course, you’ll also need to ensure that you have the income to handle the mortgage payments, especially since you’ll be paying more each month with a 15-year note than you would with a 30-year. Here is a table of your maximum monthly payment under the Dave Ramsey approach to mortgages. (I’ve assumed that the take-home pay is 75% of gross income.)
|Gross Income||Monthly Take-Home||Maximum Monthly Payment|
If you are a first-time home buyer, following Dave’s approach is going to be very difficult. Heck, it may even be difficult if you are buying your second or third home. We certainly could not have bought our first or second home under these conditions, but it’s still an approach to consider.
Related: Lenda offers terrific mortgage options if you live in TX, CA, CO, OR, AZ, IL, FL, MI, VA, GA, PA or WA
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You now know how to calculate the home that you can realistically (and responsibly) afford. Now you may have some financial plans to set in motion. Maybe you realize that you need to save up a bit more for your down payment. Or perhaps you need to adjust the home price that you’re seeking.
It’s always wise to get your credit in tip-top shape before mortgage shopping. A good credit score will help you snag the best possible interest rate available. This may take a few months (or longer!). So it’s wise to start cleaning up your report as soon as you can, if needed.
A quick way to get started on this is by signing up for Experian Boost™. This service can track your positive monthly payments and use that information to give your credit score a boost. Start now for free.
Learn More: Read our Experian Boost Review
Finally, if you are saving to buy your first home, a great tool to track your finances is Personal Capital‘s free financial dashboard. Connect your accounts and it will track your spending, saving, and even your investments.