If you are asking yourself this question before you set out in search of the perfect house, you are way ahead of the game. It is always best to know what you’re up against before your emotions get involved. You don’t want to fall in love with a house, only to discover that it is out of your reach due to pesky little matters like homeowner’s association fees, property taxes, homeowner’s insurance and PMI (private mortgage insurance).
What Makes up a House Payment?
So, what are you really looking at when you are trying to figure out what you can afford? First, is the mortgage payment itself. This will be the principal and interest you will pay every month on the loan you take out with a bank or other lending institution. Next, you must factor property taxes, which are usually assessed in a lump sum each year but are often paid in monthly installments by the homeowner along with the mortgage payments. Then, you may elect to pay your homeowner’s insurance payments the same way. If you are unable to pay 20 percent down on a conventional loan, most lenders will require you to purchase private mortgage insurance (PMI), which will also be added to your monthly payments. All these lesser discussed expenses need to be considered when formalizing your budget.
How do I Figure How Much I Can Afford on a House?
The accepted rule of thumb when figuring out how much you can afford on a house is 28 percent of your pre-tax, or gross, income. If you are married, and planning a family, before you do the calculations, you need to decide whether both of you will continue to work throughout the mortgage term. If not, you may only want to consider one income.
For example, a couple making $100,000 would divide that by 12 months, for $8,333 per month. Then, they would take 28 percent of that amount by multiplying it by .28 for a house payment of no more than $2,333. But remember, this includes real estate taxes, homeowner’s insurance, and PMI, if that applies to you. That can really reduce the mortgage payment, and therefore, the house you can afford.
What do Lenders Look at?
Lenders often call this 28 percent the “front-end” ratio. They will also look at what’s called your “back-end” ratio. This calculates your other debt; such as car payments, student loan debt, credit card debt, and other loans. This figure, which includes all your other debt, plus the mortgage debt you intend to take on, shouldn’t exceed 36 percent of your gross income. However, depending on several factors, including your creditworthiness, and the lender, your back-end ratio can go significantly higher. To figure your payment amount using the back-end ratio, just multiply your monthly gross earnings by .36 and subtract your monthly debts.
Say your other debts amounted to $800 per month. And, 36 percent of $8,333 is approximately $3,000. Now, just subtract the $800 and you have your back-end payment amount of $2,200. Your lender is going to use the lower amount as your maximum house payment.
How Much Home does this Actually Buy Me?
So, how much home does this buy you? Interest rates are constantly changing, so the actual amount is going to change according to lender, property value and how much you can afford to put down on your home. Also, the type of loan you take out will make a difference. Getting pre-qualified for a loan is one way to go.
However, a popular rule of thumb is to multiply your annual gross income by two and a half for a starting place. In our earlier example, that would mean the couple would be looking at houses in the range of about $250,000. But, as you can see from the figures below, at 5 percent interest, the payments on the loan would be $2361, which slightly exceeds the front-end payment in the example, and would not leave room for property taxes and insurance. At $200,000, the mortgage payments would be $1901, which would leave about $400 for taxes and insurance.
|(5%) Five Percent 30 Year Mortgage|
|Mortgage Principal||Monthly Payment||Interest Portion|
The important thing is to remain realistic in your expectations. Try figuring your front-end ratio and putting that money, minus current rent, aside for several months to see how that works with your budget. If it doesn’t, you may need to think about recalculating your maximum house payment to better fit your individual needs.