How Much House Can You Afford?

The question that I am asked most by potential homebuyers is “How much can we afford?”   This is a loaded question.  The first thing I tell my clients is I cannot tell you how much you can “afford”, but I can tell you how much you will qualify to borrow.  There is a distinct difference between the two and this is something that unfortunately, many homebuyers do not understand.   More on this later.

Lets examine how lenders determine how much you can borrow.  Every bank approaches this the same way and the math is extremely easy.  Lenders look at two major ratios to determine how much you can borrow:

Front Ratio 

The front ratio is the total housing payment divided by your gross monthly income.  Essentially, the front ratio tells the lender what percentage of your gross income is spent on housing.  The industry standard for the front ratio is 28%. In other words, under traditional lending guidelines, borrowers typically spend 28% of their gross income on their housing payment.

Example: If your total household income is $10,000 per month, you should be able to spend approximately $2800 on your total housing payment. $10,000 x 28% = $2800.   The total housing payment consists of principal, interest, taxes, and insurance/condo fees (PITI).

Back Ratio: 

The more important ratio is the back ratio.  The back ratio is calculated the same way as the front ratio, but this time we include your monthly debts.  The back ratio is the total housing payment PLUS any installment and revolving debt divided by your gross monthly income.  The only debts that lenders consider are installment and revolving debt.  Installment debts have the same monthly payment each month.  These are usually car or student loans.  Revolving debts are credit cards.  We use the minimum monthly payment required by your credit card company as reported on the credit report. Lenders do not consider miscellaneous debts such as cell phones or cable bills.

General underwriting guidelines stipulate that your back ratio should be 36%.  In other words, you should be able to comfortably spend 36% of your gross monthly income on housing and major debts.  In our example above, that would equate to a total of $3600.  So if we spend $2800 on our total housing payment, that leaves $800 to spend on car payments and student loans.

So what does this mean in terms of a purchase price?  A good rule of thumb to follow is you can spend 3-4x your gross annual income on a home depending on your debt load.    So if you make $100k per year, you can spend $300 – $400k pretty easily.

It is important to remember that the ratios are a guideline and they are flexible.  Most lenders will allow back ratios up to 45% without blinking an eye.  Some will even go to 50%.   I have gotten loans approved up to 65% with automated underwriting programs.   However, this does not mean you can necessarily afford to spend half of your gross income (remember, you still have to pay Uncle Sam) on a house.   This is why I said there is big difference between what a lender can qualify you for and what you can afford.  If you enjoy eating out at Spago’s, maxing out your 401k, traveling, or spending money on anything other than your house, you do not want a back ratio approaching 50% because you will be flat BROKE.  Your loan officer/mortgage broker should discuss with you debt ratios to ensure you are ready to handle the debt of homeownership.  If your loan officer has not taken the time to provide an analysis of your debt ratios, find another loan officer.

I would encourage anyone thinking of buying a home to sit down and complete a DETAILED budget prior to getting fixated on how much they want to spend on a house.  This budget should track every expenditure from your student loans to how much you spend on Starbucks coffee.  Next you need to figure out how much money you need to save each month.    After you do all of this, put away the amount you feel you can spend on a home each month into a savings account for three months.   If you can’t do this without feeling an ounce of pain, then you need to readjust your purchase price because you will be spending too much on your home.

I have some great spreadsheets that will help you budget and calculate your ratios.   As always, if you have any questions, don’t hesitate to give me a call.