“How much house can I afford?” When many people ask that question, what they are really asking is, “How much money will somebody lend me?” They sound similar at first blush, but they are actually two different questions. The first is a matter of individual circumstances – and chances are you already have a pretty good feel as to what you can shell out per month in housing costs.
The second question – “How much will somebody lend me?” is more complex. But it is actually more easily answered, because underwriting standards for the big three consumer mortgage lending sources – FHA loans, VA, or Veterans Administration loans, and conventional mortgages – are pretty well defined.
When an underwriter reviews your application, chances are they aren’t doing a very deep analysis of your credit and income processes. Instead, they are really looking over your application and supporting documents to answer one single overarching question: Does this loan fall within the lending guidelines imposed by the VA, Fannie Mae or Freddie Mac, says Fred Glick, a Pennsylvania-based mortgage expert with U.S. Mortgage Loans.
Each of the major funding sources have somewhat different guidelines. But all of them will look at a few basic elements – including the amount you have to put down, your front-end ratio and your back-end ratio. Knowing these three elements and how they apply in your situation will give you a rough estimate of how much house you can afford, says Glick.
Front-End Ratio: How Much of Your Income Goes to Housing?
In a nutshell, your front-end ratio is simply this: your total monthly housing expenses, divided by your gross income. Most lenders define monthly housing expenses according to the acronym “PITI” (pronounced “pity ratio”). PITI stands for Payment, Interest, Taxes and Insurance costs.
Here’s how this works:
You’ll do a bunch of paperwork and submit it to the lender, along with at least two years of documentation verifying your income. The lender will take this information, look up the house – or if there’s no specific house to look at yet, the mortgage – and add up all the likely monthly cash outflows using PITI.
Specifically, they’ll add up your total mortgage payment, including interest and principal. Then they’ll add in likely homeowners, fire and flood insurance premiums; homeowners’ association dues; taxes and the like – anything directly associated with housing – and they’ll add it all up.
According to the Federal Housing Authority, the maximum front-end ratio to qualify for an FHA loan is 29 percent. That is, you should be spending no more than 29 percent of your gross income on housing costs, if you want to qualify for a loan.
Back-End Ratio: How Much are You Paying on Debt?
The back-end ratio is the bankers’ way of assessing how much of your monthly income is committed to debt payments. The higher the percentage, the tougher it will be to qualify for a sizable mortgage.
You don’t need a master’s in banking to calculate your own back-end ratio. Simply start with PITI, as above. Add in any recurring credit card bills, car payments, consumer loans, and other regular monthly obligations. Then, take that amount and divide it by the gross monthly income. The maximum percentage you can have to qualify for an FHA loan is 41 percent, according to the Federal Housing Authority.
Example: Suppose you and your spouse both earn $60,000 per year. If both of you are on the mortgage application, your monthly income is $10,000 ($120,000/12) and your total monthly debt payments are $4,000, your back-end ratio is 0.40 or 40 percent. Most of the time, lenders prefer to see a back-end ratio of 36 percent or lower. But those with good credit can borrow more – and at better interest rates – and still qualify for an FHA loan with back-end numbers of up to 41 percent. Guidelines for Veterans Administration loans are similar.
You can calculate your own front-end and back-end ratios using the RealEstate.com home affordability calculator.
Your Credit Score and How it Affects Your Mortgage
Generally, the higher your credit score, the lower your interest rate. And the lower your interest rate, the lower your monthly payments on a given amount of money. Looked at another way, a lower interest rate means you can borrow more money with the same monthly payment.
As of late November, 2011, the average 30 year fixed rate mortgage was just under 4 percent, according to Fannie Mae. However, according to Glick, only those with top-flight credit scores – 760 or so and up – are qualifying for these loans.
Your Down Payment: “Skin in the Game”
For FHA and conventional mortgages, lending guidelines require at least some down payment. This payment, which can range from 5 percent and up, helps assure the lender that you have your own money in the deal as well. Since the federal government guarantees VA loans (up to $417,000 in most markets, though higher in some high-cost areas), the lender requires no down payment on these mortgages.
But consider this: If you haven’t been able to save up a reasonable down payment over a course of years, that could be a valuable signal that you cannot afford the unexpected expenses that frequently come with homeownership.
Indeed, Thomas Jensen, a fee-only financial planner in Portland, Oregon, routinely advises his clients to look at their overall situation. Have they been able to save 6 months’ worth of living expenses in a liquid emergency fund? This should come first, according to Jensen. How stable is your income? What would happen if one spouse got laid off? Walk through each scenario, and examine how much money would be available in the event of a crisis, and for how long.
This is a fundamental part of risk management, says Jensen. And ultimately will provide a more reliable guide for how much house you can afford than a generic ratio in an underwriter’s handbook.