Tired of renting? Tired of the landlord? Tired of the crazy neighbors doing who knows what and all kinds of hours? Tired of nothing but white walls in your living space? Tired of someone else parking in your parking space? Tired of paying every month and getting nothing (except maybe part of your deposit) back when you move? Perhaps it’s time to move out of your parents’ house…..
OK, so this probably isn’t your parents’ house anymore. But it may still be time to move on. Perhaps it’s time to look at buying your own home. As our clients consider a home purchase, one of the most frightening issues they face is determining exactly how much they should spend on a home.
There are a few ways to look at this, but today we are going to look at the way most lenders will qualify you for a dollar amount. Then we’ll look at the rest of the story.
Most lenders use what are called the front end and back end ratios. These are debt-to-income ratios based on your gross monthly income. I know, net income might be better, but there are so many variables in calculating net income that they use gross income. So that’s what we’ll use here.
Whether you start with an hourly salary or annual wages, make sure you use the total amount of regular pay for the year. If your income includes bonuses, commissions, or irregular overtime, that may change things, so you will need to talk with your lender more about those items. For simplicity, we are going to put you on a set income.
So congratulations, you now make $60,000 a year. But we are going to calculate what you can afford for a monthly payment as a part of your budget, so we divide the annual income by 12 months to find you have a monthly gross income of $5,000.
Front End Ratio
The front end ratio that lenders use is strictly your housing debt-to-income ratio. In other words, what percentage of your monthly gross income is going to your house payment? There are a few different percentages that may be used, but a fairly consistent standard is 36%. When we multiply your gross monthly income by 36%, we get $1,800.
That means, according to the housing debt-to-income ratio, you can spend up to $1,800 per month on your house payment.
Back End Ratio
The second bit of math they will do is the total debt-to-income, or back end ratio. This is the percentage of your gross monthly income that can go to your house payment and all other minimum debt payments that you may have. So now let’s say that on top of your house payment, you already have a car payment of $300, student loan payment of $200, and a credit card minimum payment of $125.
Again, there are different numbers used, but 43% is the ratio used for FHA loans, which are common first-time buyer loans, so we’ll use that one.
If we multiply your gross monthly income by 43%, you can now spend a total of $2,150 on all debt payments including your house payment. After subtracting your existing debt payments from that $2,150, we find you can now only qualify for a monthly house payment of $1,525.
But that’s only $275 dollars in difference. It can’t be that big of a deal, can it?
The Big Picture
In qualifying you, lenders will use the smaller of either the front end or back end amounts.
When I did the math, that difference of $275 dollars a month, at 4% interest rate on your mortgage, is a difference of about $60,000 in purchase price. Take a look at your local listings and see what $60,000 difference in purchase price makes!
In short, your other existing debt can have a big impact on the amount of mortgage you qualify for. As ready as you may be mentally to buy a home, you may want to clean up some of those smaller debts before moving forward with your purchase. It may make a big difference in getting what you really want in a home.
The Rest of the Story
So now that you know how to roughly figure what you will qualify for in a house payment, understand that these numbers are the MAXIMUM that you should be spending on your home. There are a lot of other things to consider.
Do you want to go back to school? Do you plan to purchase a new vehicle any time soon? How about toys, like a boat or 4-wheeler? Want to get a pet? There is NO SUCH THING as a free pet! Would you like to travel? Planning any kids? They are NOT cheap. What else do you want to do in life?
All of these things come with a price tag, and we only have a certain amount of money. If you want to be able to do other things, you may need to spend less on your home. I had a client in my office and as we figured it, they were spending about 16% of their income on their house payment. The conversation went something like this:
Me: “You know, you could afford a much nicer home.”
Client: “We know. But we have family in Colorado and Tennessee.”
Client: “We like to see them regularly and would rather spend a little more to fly and spend more of our time with family than spending our time driving to get there.”
By reducing their house payment, they kept room in their budget for regular plane tickets to visit family. Perfect!
So what else do you want to do in the future? What do you want to spend to be able to do those things? Are you leaving room in your budget for them? This is the bigger picture that you have to consider when deciding what to spend on your new home.
If you would like more information about the home buying process, the Center For Financial Resources offers our Homebuyer Express class. Homebuyer Express covers all aspects of buying a home from budgeting to loans, protecting yourself from predatory lenders, finding professionals to work with, shopping for a home, getting through inspections and closing, and then maintaining the home after purchase. This is a free class that may even qualify you for assistance programs and closing cost credits through the title company. You can click here to find out more about the class. Want more specific attention on your budget and credit history? CFR counselors can help with that too. Just call us at 605-330-2700 or click here to schedule an appointment.
written by Breck Miller
images courtesy freedigitalphotos.net