Buying a home can be trickier than you might think, especially if it’s your first time. You’ll naturally have questions like “How much mortgage can I afford?” and “How will a house impact the rest of my budget?” as well as many other financial concerns to think about.
Because a mortgage is so big and lasts for several decades, it’s important to choose an amount that you’ll be comfortable with both now and in the future. In this post, we’ll explore these questions more thoroughly and help you to determine how much you should spend on your next home.
What the Mortgage Company Thinks You Can Afford
From the perspective of the mortgage lender, most will follow what’s known as the 28/36 rule. This is a simple set of ratios that measures the borrower’s ability to repay the loan relative to their income and other household expenses.
28 Percent Front-End Ratio
This ratio says that no more than 28 percent of your gross monthly income (before taxes) should be spent on housing-related expenses such as your anticipated:
- Principal and Interest (P&I)
- Property taxes
- Insurance payments
- Association / condo fees (if applicable)
(The first three items are sometimes referred to as your PITI.)
For example, let’s say the gross earnings between you and your spouse are $80,000 per year. That works out to $6,667 per month. If we multiply $6,667 by 0.28, then your total housing payment should not exceed $1,867 for the month. Remember, that’s the P&I plus any other required taxes and insurance (usually rolled up into an escrow payment).
Because this ratio focuses on your income (the money coming in), that’s why it’s called the front-end ratio.
36 Percent Back-End Ratio
This ratio says that no more than 36 percent of your gross monthly income should be spent on recurring debt payments.
Your recurring debt would include things like:
- The anticipated PITI
- Credit card payments
- Auto loans
- Student loans
- Personal loans
- Child support or alimony
Using the numbers from our previous example, if we multiply $6,667 by 0.36, then your recurring debt should not exceed $2,400 for the month. That means if you ended up getting a mortgage where the PITI was $1,867, the most your other debt payments should be is $533. If your anticipated PITI was less than $1,867, then you’d have more room to have higher debts.
Because this ratio focuses on your expenses (the money going out), that’s why it’s called the back-end ratio. You’ll also hear it sometimes referred to as your debt-to-income (DTI) ratio.
Do All Mortgage Lenders Always Follow the 28/36 Rule?
Not always. The 28/36 rule is more of a guideline than a hard requirement. There are some special circumstances where exceptions can be made.
For instance, if you’re applying for an FHA (Federal Housing Agency) loan, then these percentages are increased to 31/43. However, for DTIs beyond 43, most lenders will be unlikely to approve you for a mortgage.
What Your Credit Score Says
Even if you’ve got the finances to afford a sizable mortgage, if you’ve had some hits to your credit score, then those might come back to haunt you.
Your credit score affects your mortgage in two ways:
- Whether or not you’ll get approved
- What interest rate you’ll qualify for
If You’ll Get Approved
Generally speaking, you’ll need to have at least a “fair” credit rating (FICO of 630 or higher) to get approved for most conventional loans. It is possible to have a score as low as 500 and still qualify for an FHA loan.
Your Interest Rate
Even if you do get approved for your mortgage, your credit score will directly impact what interest rate you’ll be offered. And that will determine how much your overall mortgage payment will be.
As you might guess, applicants with “excellent” or “good” credit (FICO scores of 700 or higher) will receive the best interest rates currently available. But applicants with a “fair” credit rating (FICO scores of 630 to 699) will be given a higher interest rate.
If you don’t know your FICO score, you can always check it for free using a service like Credit Karma. Oftentimes, your credit card provider will also make this information available in your user dashboard.
What Your Budget Will Allow
Perhaps the most important aspect to consider when thinking about how much mortgage you can afford is what your actual budget will permit.
For instance, let’s return to our previous example and assume your monthly income is $6,667. If you happen to have $6,000 worth of expenses (such as daycare, retirement savings, utilities, auto / life insurance, etc.), then it won’t matter that the mortgage company will approve you for up to $1,867. According to your budget, you’ve only got $667 leftover at the end of the month. That means a housing payment of $1,867 would put you in the red.
This is perhaps one of the most important steps to think about because the last thing you want to do is get yourself into debt over an expensive house payment that you can’t really afford. The best thing to do is to take a hard look at all of your expenses and determine which ones are priorities and which ones are not relative to owning a home.
The Impact of Your Down Payment
One variable that’s really going to determine how much your mortgage payment is the size of the down payment you plan to make. Most conventional mortgages expect that you will put down at least 20 percent. However, it is possible to apply for a mortgage with as little as 3.5 percent (such as an FHA loan).
For example, let’s say you’d like to buy a home that costs $250,000. If we assume you get a 30-year fixed-rate mortgage at 4.0 percent APR, then:
- With a 20 percent down payment ($50,000), your monthly P&I payment would be $955
- With a 5 percent down payment ($12,500), your monthly P&I payment would be $1,134
Note that in addition to a higher payment, most lenders will require you to purchase an additional insurance policy known as PMI (private mortgage insurance) if you bring less than 20 percent to the table. PMI is designed to protect the lender (not you) in case you default on your loan. This usually adds around $50 to $100 more to your PITI.
If you’d like to maximize your chances of saving the biggest down payment you can, then you’re going to need some help analyzing your current expenses. This is where Buxfer can help. Buxfer can break down your expenses into specific categories and provide insight into where you’re spending the most money each month.
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