How much home can you afford?

There are few things more important to me than a home buyer being able to qualify themselves, vs. taking anyone else’s word for the answer to “How Much Home Can You Afford?” Since I am a real estate agent and not a mortgage professional, I like to post a laymen’s view at least a couple of times a year on this topic. This simplistic approach should be any potential homebuyer’s first step in “the process”. I also think that any Buyer’s Agent should go through this detail with their clients before assisting them in making an offer on a house, so consider this an agent tutorial post as well.

There are many easy to use Mortgage Calculators like this one on Zillow. But just as you should know that 6 times 3 is 18 without needing to use a calculator, you should know WHY the online mortgage calculator is spitting out a number. If you know that 6 times 3 is 18, you will know if the calculator sums that out at 37, that you or it did something wrong. Same with Mortgage Calculators and Pre-Approval letters. You should know enough to know when the answer is outside of most people’s “comfort zone”.

Back to the online mortgage calculator. The first data field you need to fill out is “current combined annual income“. You need to know a few things to answer that question correctly.

1) When they say “income” they mean GROSS income, not your take-home pay.

2) If you are salaried, and make the exact same amount every paycheck, then your current salary is what goes in that data field. If any portion of your income is based on an hourly rate or a bonus for production, then your most recent income information is not usable. Unless it is a promise to pay (salary), then your “annual income” is determined by averaging your last two years worth of income AND is subject to subjective changes by the lender’s underwriter. Sometimes that happens a week before closing! So best to qualify yourself using projected, realistic potential outcomes.

If you just got a raise from $75,000 a year to $85,000 a year, and none of that $85,000 is subject to change based on hours worked or bonus income, then the full $85,000 a year goes in that box.

If you made $85,000 a year of which $60,000 is salary and $25,000 is overtime and/or bonus income, then $85,000 is NOT what you put in that box. If you had overtime and bonuses of $15,000 last year and $25,000 this year, then you add the two together and divide by 2, making your annual gross income $60,000 salary plus $20,000 of overtime and bonus pay. HOWEVER, if it is the reverse and you had $25,000 last year and $15,000 this year…not likely the lender is going to look at a figure higher than $15,000. They may impose a continued downward trend on that recent $15,000 earning vs. $25,000 the year before. In fact they could exclude it altogether as an unreliable source of income, unless your employer produces a letter guaranteeing that the overtime and bonus income will not drop below $15,000 for the next year or two.

3) “monthly child support payments” is the next line in that particular “mortgage calculator” and is the only additional income category. That doesn’t seem right at all to me. Best to contact a lender regarding all of your “other income” sources to determine which, if any, they will use. What if your child support payments are ending in 8 months? What about interest income, alimony payments, etc.? Unless you need to use these other income sources to qualify, and expect them to continue for the life of the loan, or at least for 10 years, I would suggest not including this “other” income. It will give you a “cushion” of extra monies if needed. Buy a home you can afford without these extra income considerations, if at all possible. More on this when we get to “back end ratio”.

Back to the handy but not so accurate online mortgage calculator it makes no sense to me why they would ask for HOA dues in the “income-debt” portion and then again when getting to estimated monthly payment for the new loan. In fact the whole “income and monthly debt obligations” section is poorly worded for accuracy. Once you get past income, you want to calculate your monthly “debt” payments. The most common of these are”

Car payments, Student loan payments, credit card payments, alimony or child support payments (though technically not “debt”). What you do not include are regular living expenses like utilities, gas, car insurance…all of these are not “debt’ payments.

Now skip all the way to the bottom and see the terms “front end” and “back end”. The calculator has a pre-set for 28% front end and a 36% back end. it allows you to change these pre-sets, but do not do that until you understand the numbers using the pre-sets. Assume that the pre-sets are the Average Comfort Zone for most people.

“Front-end” is your housing payment. “Back-End” is your total debt PLUS your housing payment. Old school rules work like this:

You make $10,000 a month gross at 28% = $2,800 a month for housing payment “front-end”
You make $10,000 a month gross at 36% = $3,600 a month for housing plus debt payment “back-end”.
IF your debt payments are $1,000 vs the $800 allowed, then your front end should be $2,600 vs. $2,800. $3,600 back end minus $1,000 = $2,600, so your “back end being out” reduces the amount available for housing payment by $200.
BUT that does not work in reverse. If you have NO DEBT, your housing payment stays at $2,800 and DOES NOT increase to $3,600. This based on how likely is it that you will have no debt for 30 years?

That last paragraph is the most important paragraph in this post, so take the time to understand it well.

28% front end and 36% back end has been the long term conservative approach since forever. It is also very rare that a lender will use these ratios when qualifying you for a mortgage, so YOU must do it yourself. Then when you know your payment should be $2,600 and the lender qualifies you for a payment of $3,500, you know just how much your lender is stretching you outside of conservative standards. That tells you how difficult it may be for you to actually make that payment for the next 3-5 years. A family with 4 children might only be able to spend 20% to 25% of their gross income on housing payment. A single person with a high income may be able to stretch to 33% of their gross income on housing payment. If you are a VA buyer…this is very important, as VA uses one ratio and not two (last I looked) allowing you to spend your full back end allowance on housing payment if you have no current debt.

One of the things that prompted me to write this post today was this comment I saw from a lender on Zillow:

The rules are still tightening-to a fault. Fannie Mae will soon be announcing that they are going to a 45% back end ratio and any borrower with a 620 fico score has to put down at least 20 percent. I can live with the 20 percent for a 620 fico,but the 45% back end ratio is going to make it even more difficult…

As you can see, lenders are not used to people qualifying at a conservative standard of a 36% “back end ratio” and are complaining that the rules are too tight when requiring a 45% back end ratio. OUTRAGEOUS! Remember we are using GROSS income and not net income. So 45% of your gross income on housing payment and debt is clearly NOT too “tight” of a rule.

Knowing how to qualify yourself using 28% front end and 36% back end, will help you know for yourself what monthly payment you truly can afford. Here’s my suggestion: If conservative ratios say you can afford $2,800 for a housing payment, and your lender says that number should be $3,500, test it first. If your current rent payment is $1,700, try putting $3,500 minus $1,700 in the bank every month (not on average). If you can’t put an additional $1,700 a month in the bank easily, each and every month for at least 6-9 months, don’t consider buying a house at the max your lender “says” you can afford.

In fact regardless of the ratios, it’s a very good idea for you to pretend you have that new housing payment well in advance of making an offer to purchase. Test for yourself, by banking the difference, before taking on that 30 year obligation to pay.

11 thoughts on “How much home can you afford?

  1. Hi Ardell,

    Nice write up. There is a difference between what you qualify for versus what you want to pay. Those are two questions we always try to get right. Sometimes, it’s a great divide!

    On the 45 max DTI, I remember when the box was a strict 28/36 and see the merit of it. However, I don’t think it applies to high income borrowers nor should it apply to those who are making timely payments and want to reduce their payments regardless of DTI. Had one of the latter today.

    Cheers – Chik

    • P.S. to Chik’s comment for readers. Chik is a mortgage guy. DTI ratio = Debt to Income Ratio which includes your new mortgage payment plus your other debt payments. In terms of this post, DTI would be the “back end” number.

      Lately I’ve been wondering whether to include cell phone payments for families with 4 more more cell phones 🙂 It’s become a pretty standard household expense, and not a small one. If you use conservative back end numbers of 36 or 38…not a big deal. But if you are stretching the back end without counting cell phone bills, it could lead to trouble down the road.

      • You have an interesting point with cell phones. I think a better measure would be the actual new expenses added as a result of owning a new home such as water and sewer, electricity, gas, recycle and Garbage. These are real new expenses when owning a home. Four cell phone may still be in a household regardless of renting or owning. Thought?

        • Chik,

          Normal utility bills are already part of the 28/36 allowance. Unless you think the % of those has changed over the years, but I don’t think it has. When 28/36 was “invented”, the remaining 64% accounted for water and sewer, electricity, gas and trash…food too, but not newer everyday expenses like cell phones.

          It did account for landline usage, but seems to me cell phone bills do not reflect the same proportion of gross income that old landline usage did.

  2. Hi Chik,

    I agree on the REFI that less is best as to new monthly payment, but being a real estate agent, I’m rarely talking about people who are refinancing. As to 28/36, stretching to 31/45 or 33/42 may not be the end of the world, but I still think people should know they are stretching when they do that, so they know not to add more debt when they buy the house. One of the problems with stretching is it tends to lead to less disposable income and gradually increasing debt that pushes the back end out even further over the years.

    Knowing 28/36 is the goal helps people back into it, even if it is in the years after purchase.

    • You would be surprised (or maybe not) how often I meet with first time home buyers who are upset with me because they’re only approved to buy X when they really want X+Y…well beyond the ratios you’re referring to. With the home buying process, many wind up with stars in their eyes instead of really visualizing what the cost and future lifestyle (eeking by) may be when they are not realistic with their budgets.

      Guidelines will continue to get tougher…

  3. Carin,

    When I was a new agent (back in the dark ages) I was trained to do it backwards. I would hold up the calculator and say “you need to make about this much to buy this home” before writing the offer. It really is as simple as that, depending on debt issues and long term stability of the income source(s). It normally works out to between 3 and 4 times their gross income.

    The devil is in the details, and since we as agents generally spend a lot more time with the buyers, it’s helpful to know the red flags like hourly and bonus income. We didn’t generally have pre-approval letters submitted with offers when I started. Buyer’s submitted a financial statement to the seller (by law at that time in PA) and it was the agent’s job to consider ability to finance prior to offer acceptance.

    Knock on wood…I don’t think I’ve ever had a contract not close over ability to finance issues. No honor in that over the last 5 years of loose lending, but in the remaining 15 years it is an agent skillset vs. simply getting a lender’s opinion.

    Fewer car companies allowing leases may help with the back end, as more people may eventually own at least one of their cars and not always have two high car payments. The acceleration of “car debt” in this Country has been problematic. Some couples pay more in car payments than they do for monthly rent.

  4. Pingback: You should NOT be buying a house if you don’t “get” this. | Rain City Guide

Leave a Reply