Where do you start with a home affordability estimate? Yes, there’s probably some math involved, but how?
Understanding what you can afford has a lot to do with your income, but it also has a lot to do with your personal debts, savings, and credit, along with the other costs that will make up your total housing costs.
Make a Rough Estimate
First things first, you can do some very simple math and get a rough — we mean very rough — estimate of what you can afford.
In general, a prospective buyer could likely afford a home that costs 2 to 2.5 times their annual gross income. So if you bring in $80,000, that’s a house that’s between $160,000 and $200,000.
But this estimate leaves out whether or not you can make a 20% down payment, whether or not you have good credit, and importantly, what other expenses you need to keep up with.
Figure Out Your Debt-to-Income Ratio
Speaking of those other expenses, you’ll need to know your two debt-to-income ratios — what percentage of your monthly income would hypothetically go toward your new home payments and those housing expenses plus your other ongoing expenses. As far as lenders are concerned, these numbers play a big role in what you can afford.
A front-end debt-to-income ratio looks at how much of your monthly income goes toward your housing expenses. Lenders add up a home loan’s principal, interest, taxes, and insurance and divide it by your gross monthly income. It’s ideal if these home loan costs don’t exceed 28% of your gross income, but many lenders will be okay with a higher number.
A back-end debt-to-income ratio throws several more expenses into the mix. These other expenses could include credit card payments, car payments, student loans, and more. That obviously means this ratio is going to be a higher portion of your gross monthly income. Still, lenders don’t want this number to be too high. Ideally, most lenders want to see this number below 36%, though many would accept a borrower with a ratio below 45%.
Take Some Detailed Calculations
Getting an accurate figure for your debt-to-income ratio may take some work. Your gross income isn’t just your salary. Wages, bonuses, investments, dividends, alimony, and other sources of income should be factored into your gross monthly income estimate, too.
When you calculate your monthly expenses, factor in the minimum payment due for credit cards, your monthly car payments, student loan payments, alimony payments, and other recurring expenses.
Ask About Your Lender’s Requirements
In one sense, the question isn’t “What can I afford?” It’s “What will the lender let me buy?”
Lenders may suggest an ideal ratio for a borrower, but when it comes to upper limits, there are strict requirements for your debt-to-income ratio.
You’ll often see these DTI limits expressed as 30/45, meaning your mortgage payment (principal, interest, taxes, and insurance) can’t exceed 30% of your monthly gross income and your housing expenses and other monthly debts together can’t exceed 45% of your monthly gross income.
The debt-to-income limits of different lenders may vary slightly, but for each lender these limits are non-negotiable.
Other Points to Consider
While a lender’s DTI limit may be fixed, there are moves you could make to bring your ratio down. For instance:
- A higher down payment would reduce your monthly housing expense, lowering your ratio.
- Paying a car off early or paying off and closing a credit card would also help your back end ratio.
- Even securing a lower interest rate would help by reducing your monthly mortgage payment and lowering your ratio.
Lastly, just because you can afford to buy x amount of house, doesn’t mean you should. You might become “house poor” — meaning you’ve got a great home, but not much money for anything else.