How Much Home Can You Afford?

By: Jerry

"How much home can I afford?" That's a question people should start asking themselves well before they preview homes. A pre-approval letter from your lender is the single best resource for estimating how much you can afford before you buy.

Today lenders are much more cautious and are going to take a much harder look at how much home you can afford when it's time to fill out a loan application.  Keep in mind however, this is what the lender is comfortable lending you, not necessarily what you'll be comfortable with spending every month.

Figuring Out How Much Home Can You Afford

If you're not yet ready to talk with lenders you can still get a fair estimate of what you're comfortable spending on your own using the same methods that lenders use.

• Front-end Ratios. Lenders look at the "front-end ratio", the percentage of your gross (NOT net) monthly income that your mortgage payment should not exceed.  The front-end ratio for an FHA loan is 29%; for a conventional loan, it's usually 33%.  In other words, if your gross monthly income is $3000 your mortgage payment should be about $1000 or less. Again this is the comfort zone for lenders. After taxes, can you afford the payment along with gas, insurance, clothes for the kids, grocery bills, utilities and entertainment?
• Back-end ratios.  Back-end ratio is calculated by adding the mortgage payment in with other recurring debt payments (such as a car loan).  For an FHA loan, the back-end ratio is 41%; for conforming conventional loans, it's 45%.  Again, this is calculated from your gross income, not your post-tax take-home pay. So if more than 12% of your income is currently going to pay debts you need to lower the front-end ratio percentage to make up for it.
• Home Prices.  In addition to calculating a rough idea of your front-end and back-end ratios, you can also use home prices themselves to get an idea of how much you can afford.  The rule of thumb is that a monthly payment works out to be roughly 1% of the home's price, such as $1000/month for a $100,000 house. 

This will all hinge, however, on prevailing interest rates and the structure of your loan as well as how much of a down payment you plan to put on the home. 

Factoring in Down Payments

Down payments will be a big variable and something that has to be accounted for when determining how much you're comfortable with spending on a home. 

• VA loans and certain low-income housing programs will allow for zero down payments.
• FHA loans will typically call for a 3.5% down payment, which would come out to roughly $5000 on a $150,000 house.
• Conventional loans will range from 5% to 15% for a down payment; 5% on a $160,000 house will come to roughly $8,000.

You'll have to have this cash on hand to bring to the table at close. Since most of us don't have thousands of dollars to spend at any given moment, this will require planning and saving well in advance.

Other Costs to Consider When Deciding How Much Home You Can Afford

Remember that if your loan is for more than 80% of purchase price will also have to carry private mortgage insurance, which will increase your monthly payment by roughly $50-80.

Closing costs also need to be taken into account.  On a $150,000 house, closing costs could be in excess of $4,000, which will be above and beyond your down payment.  It is possible to negotiate for the sellers to pay all or part of a buyer's closing costs, or closing costs could be rolled into the note itself, but that's not a guarantee. 

You'll also want to consider what other big financial decisions lay on the horizon. Are you planning on retiring in the next few years? Are you sending a child to college or planning to earn a degree yourself? Are you planning on making a big career change soon? How are these events going to affect your debt and income? You'll likely have mortgage payments for many years down the line so you can't just think about your finances today.

In any case, it's not wise to completely clean out your account to come up with a down payment and closing costs. It may make more fiscal sense to keep renting vs owning a home.  If at all possible, try to keep a healthy cushion of money in reserve for emergencies.

Armed with this knowledge, "how much can I afford to spend on a home" is a question that you can answer confidently.