How much home can you afford? It depends on who you ask -- a mortgage calculator will tell you one thing, an underwriter can give you a better idea, a good loan officer can help you more, the government will tell you something else and your accountant has his/her own idea.
But the highest authority is your gut, plain and simple. Run some numbers, envision several scenarios and then choose a price and a payment that you won't lose sleep over.
The Rule of Thumb
Everyone has a favorite rule of thumb for mortgage affordability. A common one is that you shouldn't finance more than three times your annual income.
This rule has very obvious flaws. One major flaw is that it doesn't take current mortgage rates into account. Your interest rate directly affects how much loan you can qualify for. If you earn $100,000 a year, that means you can finance up to $300,000 under this rule. Your gross earnings are $8,333 per month. At a 5% interest rate on a 30-year loan, you'd have a monthly payment of $1,610 before taxes and insurance (at a 6% interest rate on a 30-year loan, you'd have a monthly payment of $1,798 before taxes and insurance). If taxes and insurance were $400 a month, your housing expense would be just over $2,000 a month -- or less than 25% of your gross income. By most mortgage underwriting standards, you could actually qualify for a considerably higher loan balance. This very general rule also fails to consider your other debt expenses.
Debt-to-income ratios are the province of mortgage calculators. One important ratio, referred to by mortgage professionals as your "front-end" or "top-end" ratio, is calculated by taking your proposed housing expense -- including mortgage principal and interest, property taxes, hazard insurance, homeowners' association dues (if applicable) and mortgage insurance (when required) -- divided by your gross (before-tax) income. Many mortgage calculators set 28% as the desirable value for this ratio.
The other ratio to think about is all of your loan payments -- not only housing expenses but also consumer payments on credit cards, auto loans, student loans and similar obligations (but not utilities or other living expenses) -- divided by your gross monthly income. Mortgage calculators frequently set this number at 36%. This is called your "back-end" or "bottom-end" ratio. If a lender says you have an ugly back-end, he or she means you have too many commitments against your income.
Automated underwriting systems (AUS) take a little more information into account. They adjust the amount you may qualify for up or down according to their proprietary formulas. Your credit rating, job stability, assets and down payment all influence how high a ratio an AUS considers acceptable. For example, the number of months' payments you have in the bank is referred to as your reserves, and the more months of reserves you have, the higher your ratios can be.
Human underwriters have more latitude. Look at what the Federal Housing Administration (FHA) directs its underwriters to consider when analyzing applicants' ratios: Front-end ratios of 29% or less and back-end ratios of 41% or less are automatically acceptable. However, compensating factors allow the underwriter to approve loans with considerably higher ratios. Here are some of the many compensating factors:
- You have demonstrated the ability to successfully pay housing expenses equal to or more than the proposed monthly housing expense.
- Your down payment is at least 10%.
- You have demonstrated the ability to save money and use credit sparingly.
- You have the potential for increased income (for instance, only a human underwriter will know that you just graduated from medical school).
- You have at least three month's reserves after closing on the home.
- Your housing expense won't increase substantially.
- Your spouse is unemployed but looking for work.
- Your other debts are very low, allowing you to manage a higher house payment.
"Payment shock" is one factor that underwriters consider, and you should too. Payment shock is the difference between your current housing expense and your new house payment. For example, if your rent is $1,000 per month but your proposed house payment is $2,000 per month, you'd better consider where the extra money is coming from. To help keep you from getting in financial trouble, an underwriter (automated or human) will probably approve you at a lower debt-to-income ratio to keep your new payment closer to what you have already comfortably managed.
Only you know how well a proposed mortgage payment, complete with taxes and insurance, will fit into your life. On paper, you may qualify for a lot more or a lot less than you should spend. So when determining what you can afford, sketch out what you think your life may look like one, five or 10 years down the road. Look at your goals and what kind of money you need to meet them, and where it's going to come from. Decide what payment works for you, and then enter the current mortgage rate into a mortgage calculator to find a projected loan amount and maximum purchase price.
Then, ignore the rules and run it by your gut. Remember, few borrowers got into trouble by borrowing less than the absolute maximum they could.
Gina Pogol has been writing about mortgage and finance since 1994. In addition to a decade in mortgage lending, she has worked as a business credit systems consultant for Experian and as an accountant for Deloitte.