If you are looking to purchase a home, a popular question that you will need an answer to is, “How much home can I afford?” The short answer is that it depends. There are two methods that a mortgage lender can use to find your maximum home purchase price.
1. Debt-to-Income Ratio
When using the debt-to-income ratio method, the financial institution considers your annual income and annual debts. Your debt-to-income ratio is considered in two parts: front-end ratio and back-end ratio.
The front-end ratio compares the expected monthly housing payment to the buyer’s monthly income. Lenders like to see this number at 28% or less which means that 28% or less of your monthly income will be utilized for your housing payment.
The back-end ratio looks at monthly housing payments and other monthly expenses such as credit card payments, child support, car payments, and other loan payments. The ideal back-end ratio is 36% or less.
This data is then used to find the largest mortgage payment you would be able to make without raising your debt-to-income ratio above allowable maximums. Once the lender has found your maximum mortgage payment, the current mortgage rates are used to figure out the size of loan which tells you how much you can borrow.
While the debt-to-income is effective, it can also be dangerous. This method is based on borrowing the absolute maximum that you get approved for. However, this is not always the best financial move to make. It’s similar to the concept of credit. Just because you have a $5,000 limit on your credit card, it does not mean you should use all of it. Financial institutions cannot tell you what you should be paying and only give you the information for what you could pay.
2. Create a Monthly Household Budget
The second approach is more personal. If you borrow at the maximum you are approved for, you will not have much money to put away in savings, invest, or for living expenses. By using this method, you can see how much home you can afford by looking at the money you have left over to spend on a house. Determine the maximum monthly payment you would like to pay each month by closely analyzing your budget. You can then use a mortgage calculator and enter the monthly payment you want along with the current mortgage rates and it will calculate the amount of the loan that your monthly payment could afford.
This method can help you stay more accountable when it comes to staying on budget. It’s going to be tempting to go over your monthly budget to seek more expensive housing options knowing that you were approved for a higher loan. However, spending more than what is feasible for your budget and spread your money thin and you might not be able to afford other living expenses and needs.