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. However, you have to remember that there is a difference between what you qualify for and what you can afford! The lender does not review all of your miscellaneous expenses! For example, if you are spending $1500 a month on day care, the bank does not take that into account and that expense can severely throw off the standard affordability guidelines stated above.
Every home buyer should sit down and do a detailed budget that looks at how much you spend on everything from gas to cigarettes to Starbucks to student loans. Based on that budget, you then work backwards into what would be a comfortable monthly PITI which is then used to determine how much you can spend on the home.
