P articularly for those looking to buy their first home, the big question is always, “How much house can I afford.” I can still remember my wife and I trying to crunch the numbers when we bought our first home back in 1993. I was scared to death that we wouldn’t be able to afford the mortgage payments. But we did, and as the months and years went by, our mortgage payments became more manageable.
If you’re considering buying a home, it helps to have an idea of how much you can afford. It’s very important to think of this question from two different perspectives. The first is simply how big of a mortgage will you qualify for. The answer to this question depends on a lot of factors, including your income, existing debts, interest rates, credit history and your credit score. We’ll look at several calculations that most lenders use to evaluate mortgage applicants.
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.
With that, let’s look at 5 ways to calculate how much house you can afford, beginning with a standard rule of thumb:
2.5 to 3 Times Your Annual Income
This was the basic rule of thumb for many years. Simply take your gross income and multiple it by 2.5 or 3 to get the maximum value of the home you can afford. For somebody making $100,000, the maximum purchase price would be $250,000 to $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 can net your 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 some suggest higher or lower multiples. I’ve seen banks recommend ratios as low as 1.5 times salary or as high as 5 times salary. I think that for most situations, a good starting point is 2.5x your income.
The 28% Front End Ratio
When banks evaluate your home loan application, one very important calculation is known as your housing expense to income ratio. Also called the front-end ratio, banks will take your projected housing expense for the home you want to buy (principal, interest, taxes and insurance) and divide by your total monthly income. Generally, mortgage companies are looking for a ratio of 28% or less.
For example, if your income is $10,000 a month, most banks will qualify you for a loan (subject to other factors, of course) so long as your total housing expenses does not exceed $2,800 each month. While the 28% mortgage to income ratio is followed by many institutions, some will qualify a borrower with a slightly higher ratio.
The 36% Rule
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, it takes your total monthly minimum debt payments and divides by your gross income. Debt payments include not only your projected mortgage, but also minimum credit card payments, car loan payments, school loan payments, and any other payments on debt.
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% and 36% numbers, here is a chart showing the calculations for various income levels: