“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.
{ 15 comments… read them below or add one }
Very good explanation of the criteria to determine how much a home buyer will qualify for. I like the video.
my husband and I are looking to buy a mobile or manufactured home. there are quite a few that is within our price range so we can comfortably afford to do this. we called one agent to look at a home and was told “no one will work with us because we have low credit, there are only 4 lenders that work with mobile homes and none will work with anyone with a credit score under 660, stop trying untill your credit is better then call me.” we have a lender that will work with us for the price we are looking for. so I don’t belive what she is saying, but we can not find a realitor that is willing to show us any homes. does anyone have any information about why we “can’t” get a manufactured home with low credit or is there someone out there willing to work with us?
ps we are looking in Orange County CA thank you!
Hi, I was thinking of buying a second home (investment property). What are the steps of buying a second home. Will I need a larger down payment, higher interest rate? What is the fine print? I already have a would be tenant in mind for the second home does that help my case?
you will need 20-25% down of what ever the Sales Price is , rates are higher for Investment properties, than 2nd homes . If you are going to rent it then that makes it an investment property , if your going to use it for your personal use than you can do 2nd home. What part of the country are you looking at ?
This is the first time we are looking for houses can u suggest us what are the steps we start with.
Hello, Fatima, and thank you for writing in.
There is a section here on RealEstate.com that’s geared to first-time homebuyers. I would start there, and scroll around.
Incidentally, I’d like to address something if you happen to be an observant Muslim (I’m just going by your name here, but other readers may like to know this as well):
Borrowing money to finance a home, or anything else, can be an issue for observant Muslims. This is because Islam forbids charging usury, or interest, on borrowed money.
As a result, observant Muslims sometimes don’t take out a home loan in the usual way we think of it in the United States. Instead, there is a sub-industry called Shariah-compliant financing. You accomplish the same thing – but the financing is structured differently to avoid the charge of interest. Instead, you and your bank buy the house as partners. And then, over time, you buy a fraction of the house back from the bank every month, and pay the bank a fee. You can still buy a house, and the prohibition against usury is observed.
Thanks for reading!
Jason
How forgiving can banks afford to be under the following circumstances:
Bankruptcy @ 2 years old.
If a family is paying 1100.00 rent for an apartment and the mortgage for a home is much smaller, is that taken into account? I guess the question is, is past payment history taken into account?
Hello, and again, thanks for reading and for your query!
It’s ALL taken into account. But understand that most banks need to sell their mortgages upstream to Fannie Mae and Freddie Mac, and they only buy mortgages that meet certain qualifications… among which are the income and debt parameters outlined above.
Might be tough to do it just a couple of years out of bankruptcy, if you’re working with a big institution, like a bank. You might have more luck working with an experienced mortgage broker, who can write for a number of different mortgage companies which may be willing to work with you. You may need to pay a higher down payment. But that’s not a terrible thing, in and of itself. If you’re an investor, the most important metric is the LTV, or loan to value. Is the property adequate collateral for the deal? If so, keep shopping around. Lenders are still in the business of lending! Be conservative, be cautious, and don’t paint yourself into a corner. If you’re conservative and cautious long enough, the lenders will beat a path to your door.
Can there be co-ower’s on properity?
Hello, and thanks for writing and commenting.
That’s actually a pretty big question. The short answer is “yes,” there can, indeed, be co-owners on property. The long answer is that there are several different types of co-ownership, such as tenancy in common, tenancy by the entirety, etc.
These are legal terms that define the nature of the interest you have in the property, and how it can be transferred, assigned, or inherited. For example, when one partner dies, does the surviving partner own the whole property? Or does the interest in the property go to the deceased’s heirs. When one partner is sued, can creditors strip the other partner of his interest in the property, too? Under what circumstances?
This may well be the subject of one or more future articles. Stay tuned!
Jason
A wonderful job. Super helpful information.
Hello, and thanks for writing and commenting!
One of the issues leading to the overheating of real estate prices (and the subsequent collapse) was definitely the erosion of lending standards. Its roots were actually not even in the U.S., but in China and Asia, in general. Those folks save like crazy. Their savings rates dwarf those of Americans, and their bankers had to put all that money to work somewhere. And so there was a tsunami of Asian cash flooding into the American real estate market. Bankers had to do SOMETHING wwith it, and the only thing most of them do is lend money on houses. The more cash they were struggling to lend, the more they had to lower standards. Meanwhile, the lenders were also compensating their mortgage salespeople by the deal and the dollar volume – without regard to whether the loan would be paid back! Why should they? They thought they could just sell the loan to Fannie Mae and Freddie Mac, who would give them more cash that they could lend again! And so we had mortgage lenders accepting “no documentation” loans, secured only by the underlying (and overinflated) real estate. Later we had “NINJA” (No income, no job application) loans, and no shortage of outright mortgage fraud. In theory, we always had some underwriting standards, though they tightened up a lot since 2008. In reality, we forgot what they were. Those sounding the warning bells were all but accused of being un-American!
Thanks again for reading, and commenting. Lots more on the way!
Jason
Very informative although I kept wondering how all these sub prime mortgages were done if all these parameters were actually in place at the time….or were they?
This was helpful. I had not heard the terms front-end and back-end ratios before, even though I knew that all of these factors are taken into account. Thanks!
Thanks for writing such an easy-to-understand article on this topic.