According to the census bureau, the median selling price for a new home in November 2018 was $302,400. Unless you have this kind of money lying about, getting a mortgage is your only option if you want to buy a home.
You’re not alone. According to an NAR report, 88% of home buyers financed their purchase in 2017, borrowing a median 90% of the purchase price.
While a mortgage is a reality for most, it raises two critical questions. First, how much house can you afford? Second, and arguably more important, how much should you spend on a house.
The first question often comes down to how much you can borrow. This in turn depends on a number of factors, including your income, credit score, other debts and your down payment. The second question is more nuanced. Just because you qualify for a large mortgage, doesn’t mean taking it out is a smart move.
We’ll tackle both of these questions.
How Much House Can You Afford?
There are a number of factors that go into the underwriting process for a mortgage. Some of these factors determine whether you qualify for a loan. Other factors go to what interest rate you’ll pay. In combination, all of these factors influence how much you can borrow.
Your debt-to-income ratio
Mortgage lenders look at what’s called your debt-to-income (DTI) ratio. In simplest terms, DTI compares your monthly minimum debt payments to your gross income. Your DTI ratio has two components: the front-end ratio and the back-end ratio.
Front-end ratio
The front-end ratio compares your monthly housing costs to your monthly income. To calculate your front-end ratio, divide your expected mortgage payment, including taxes and insurance, by your gross monthly income.
Historically, banks wanted to see a front-end ratio no higher than 28%. In other words, for every $1,000 in monthly income, a potential home buyer could allocate no more than $280 to housing costs. Today, this rule has been relaxed, and the focus has shifted to the back-end ratio.
Back-end ratio
The back-end ratio compares all of your monthly debt payments to your monthly income. To calculate your back-end ratio, divide your entire monthly debt, including your expected mortgage payment, car payment, credit cards, student loans and other monthly payments, by your monthly income.
Historically, banks wanted to see a back-end DTI no higher than 36%. Along with the front-end ratio, these DTI measures are known as the 28/36 rule.
The 28/36 rule is a guideline. Lenders can vary these parameters based on a borrower’s credit score, potentially allowing higher scoring borrowers to have a slightly higher debt to income ratio. Furthermore, government programs can allow for higher DTI Ratios.
According to the Consumer Financial Protection Bureau, a 43% back-end DTI is the highest ratio a borrower can have and still get a Qualified Mortgage. A Qualified Mortgage (QM) is one that meets certain standards designed to protect borrowers. Among other things, a QM requires a borrower’s total debt payments not exceed 43% of their pre-tax income.
This is not to be confused with loans meeting requirements set by Freddie Mac and Fannie Mae, which have their own DTI requirements. Fannie Mae and Freddie Mac loans allow back-end ratios of 45% to 50% with compensating factors, such as plentiful assets or a larger down payment.
As liberal as the DTI requirements have become, their importance cannot be overstated. According to the NAR report cited above, 15% of mortgage applications were denied because the DTI requirements weren’t satisfied.
Your credit score
An individual’s credit history is a major factor in the mortgage process. It’s a big factor in determining the interest rate, which in turn affects your monthly payment and DTI. It can even affect the required down payment. According to the FHA, applicants are required to have a minimum FICO score of 580 to qualify for the low down payment advantage, which is currently around 3.5 percent.
This difference in credit scores can amount to tens of thousands of dollars over the life of a loan. According to myfico.com, a person with a FICO score of 760 or better will enjoy a significantly lower mortgage rate than a person with a FICO score of 620. Thus, to understand how large a mortgage you can get, you must know your FICO score.
Your down payment
The size of your down payment is another factor that determines how much house you can afford. The down payment comes into play for several reasons.
First, and most obvious, the larger the down payment, the more you can afford to spend on a home, all other things being equal.
Second, the size of your down payment can affect your monthly mortgage payment. For down payments of less than 20 percent, buyers are usually required to pay for private mortgage insurance (PMI). This additional payment increases your monthly housing costs, thus affecting your front-end and back-end DTI ratios. Ideally, buyers should aim to make a down payment of 20 percent or more to avoid PMI. (Note: PMI protects the lender, not you, so it’s an expense that’s best avoided.)
Third, your down payment can affect your interest rate. Generally, a larger down payment means a lower interest rate, according to the CFPB. The lower rate not only brings down your monthly payment, but it also lowers your DTI ratios.
Bringing it all together
As you can see, there are a number of factors that determine how large of a mortgage you can get. If you get access to your FICO score and crunch some numbers, you can get a rough idea of your borrowing capacity. You can also seek assistance from your bank or a mortgage broker.
All of this, however, still leaves one important question.
How much should you spend on a home?
Just because a lender will give you a certain loan amount doesn’t mean it’s a smart decision. In fact, borrowing the maximum is often a grave mistake. What’s more, rules of thumb fall short. What DTI ratio might be comfortable for a family earning $250,000 a year might not work for a family earning $75,000 a year, as financial planning guru Michael Kitces has pointed out.
Instead, consider the following factors as you determine what’s best for your situation.
Have you accounted for your other financial goals? Here you might consider retirement savings in a 401(k) or IRA, saving for a child’s education, and saving for emergencies.
Are you qualifying for a mortgage based on one or two incomes? If you are using two incomes, do you plan for one spouse to stay home with children at some point? Are both incomes secure, or is there a meaningful risk of losing an income without a ready replacement? If so, the loss of one income should be considered in the decision.
Are you buying a new home or a fixer upper? If it’s a fixer upper, you should consider the costs necessary to renovate the home.
In other words, make sure the proposed mortgage fits in with your lifestyle and other financial goals. Ultimately, remember to ask how much house can you afford while still being able to enjoy the other things in life.
