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“How Much Can I Borrow To Buy A House?”: The Tricky Question Of How Much Home You Can Afford

A conversation with a handful of realtors will reveal to you a somewhat surprising truth: many people begin looking for a home to buy before they even know what price range they fit in, or before they get pre-approved for a mortgage. (Please note that we did say pre-approved and not pre-qualified, the difference is quite substantial; it is, though, beyond the scope of this post and might be the subject of a specific article later on) This is a very inefficient use of their time, one that can potentially cost them thousands of dollars if they put in a binding offer on a house and then find out that they’re unable to secure the necessary financing to complete the purchase.

So before you start looking at homes, you need to have a very good idea of what you can afford. Making sure you’re focusing your house hunt on homes that are within your price range will save you time, trouble, and money. The question “How much can I borrow to buy a house” is one that needs a very precise answer, because there’s literally a lot riding on it.

One of the best ways to find out how much home you can afford is to get pre-approved for a mortgage by a reputable mortgage broker or bank. Five main factors will determine how much home you can ultimately afford:

• your monthly income
• your debt
• your available cash
• your credit history
• your interest rate

Income

There are two debt-to-income ratios that banks calculate, based on the information you provide on your loan application. The first one, called the front-end ratio, checks how much of your income would go toward your mortgage payment. The guideline for this ratio is that your total payment (principal, interest, property taxes, and homeowners insurance) should not exceed 28% of your gross (that means pre-tax) monthly salary. To calculate your front-end ratio yourself, take your annual salary and multiply it by 0.28, then divide it by 12. The figure you get is your maximum mortgage payment per month.

You can count as income not only your steady employment but also:

* overtime bonus and commissions (average for one – two years);
* net income from self employment;
* social security, veteran’s benefits and retirement;
* alimony, child support and income from public assistance programs;
* workman’s compensation or permanent disability payments;
* interest and dividend income; rental income after deducting expenses and debt payments;
* income from trusts, partnerships, professional corporations and so on.

If you have no idea of what your property taxes or homeowners insurance will be, the following median statistical meanings can be used. According to the American Housing Survey data the median annual taxes per $1,000 value averages $12. The median property insurance costs per month averages $30.

The second debt-to-income ratio is called the back-end ratio, which brings us to your debt.

Debt

Banks also take into consideration your regular monthly debts and obligations to check how much of your gross income is required to pay all of your debts combined. This is called your back-end ratio and includes the mortgage as well as other installment loans (bank loans, auto loans, student loans), credit card payments, revolving accounts, and child support and alimony payments. Their guideline for this ratio is that your total debt payments should not be more than 36% of your gross income. To calculate your back-end ratio yourself, take your annual salary and multiply it by 0.36, then divide it by 12. This is the maximum allowable amount of your total monthly debt payments.

With that in mind, you can clearly see why most experts recommend that you pay off as much debt as possible before applying for a mortgage. It gives you that much more flexibility when it comes to the amount of mortgage debt that you can realistically take on. Knowing what monthly mortgage payment you can afford helps you determine not only the maximum loan amount you can possibly borrow, but it also helps you decide what type of mortgage loan is right for you. You may find that you preferred type of mortgage is not something that you can sustain and be forced to reconsider. Better do that sooner rather than later.

Available cash for down payment and closing costs

You’re expected to have enough money to cover both the down payment (anywhere between 3 percent and 20 percent of the house’s asking price) and the closing costs (3 percent to 6 percent of the loan amount). Zero down loans have dried up lately, so you shouldn’t really rely on them. You can use the following to build up your stash of cash:

• Earnest Money Deposit
• Savings and Checking Accounts
• Cash saved at home
• Private savings club
• Savings Bonds
• IRAs
• 401 (k) and Keogh Accounts
• Stocks and Bonds
• Thrift Savings Plans
• Gift Funds
• Sales Proceeds
• Sale of personal property
• Commissions from sale
• Trade Equity
• Rent Credit
• Sweat Equity
• Collateralized Loans
• Disaster Relief Grants and Loans
• Employer’s Guarantee Plans
• Employer Assistance Plans

If you don’t have enough money for down payment that most lenders require, you may obtain Private Mortgage Insurance (although there are ways to avoid paying PMI even without a 20 percent down payment). It allows you to get a mortgage loan with a down payment as low as 3 percent. Your local government may support other home buying programs in your area. You may be able to find out more information about local home buying programs on your city, county, or state’s home page.

Credit History

This has been covered extensively in a previous post: Fix Your Credit First! First Time Home Buying Tips.

Interest rate

The truth is that all the aforementioned factors will weigh in on how good an interest rate you’ll be able to secure on your loan. If you happen to have good income, low debt, a sizable down payment and good credit, you will get a good interest rate when compared to what the market is bearing. But there’s a part that you have no control over, and that’s the current economic climate. Depending on how the economy is doing, rates might be either high across the board or low across the board. Nevertheless, it’s always a good idea to try and get your financial situation in its finest possible shape so you can negotiate excellent terms on your mortgage loan.

There are plenty of online calculators to determine mortgage affordability calculators based on your personal financial information. They can estimate your mortgage payment, and you can use them in conjunction with other online calculators which can help you decide whether you’re better off continuing to rent or buying a house.

Keep in mind that the maximum amount of money you get approved for is not necessarily the best amount to actually borrow. Owning a house involves a lot more expenses than the mortgage payments, insurance, and property taxes. For example, when you own your home there’s no landlord to call and make repairs, and you can never know how expensive a repair you’ll face until it actually happens. Similarly, home ownership also involves upkeep, such as a lawnmower to cut the grass, or technicians to keep the A/C or heating units running smoothly. Those are concerns you never have to deal with as a renter, but as a homeowner, you have to not only acknowledge them but also pay for them. Accepting the highest amount you qualify for may result in financial problems down the road as you struggle to maintain a housing payment and all the accompanying expenses that come along with it.

Consider your own budget and lifestyle, and make sure you don’t end up with such a high mortgage payment that you can’t put money away for retirement, go for a nice vacation, or even go out to eat. Some debt counselors recommend that your total payment should not be more than 28% of your net pay (after taxes), leaving you money for a comfortable lifestyle as well as the other costs of home ownership, such as repairs, maintenance, and higher utility bills. Another common rule of thumb is to not buy a house that costs more than two and a half times your current annual salary.

“How Much Can I Borrow To Buy A House?”: The Tricky Question Of How Much Home You Can Afford

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