So, you’ve decided it’s time to buy a house (usually a good decision)! If you have trunks of cash lying around, determining how much of a home you can buy is fairly easy. $150,000 in cash buys $150,000 in house. But if you’re like the rest of us, you’ll need to turn to a mortgage to finance your new home.
Attempting to sum up in one blog post what essentially takes up my entire work week (and that of processors, underwriters, etc.) is tricky. There are so many variables that you need to—please—take this with a grain of salt! This information should be enough to get you thinking; but when it comes time to truly determine your mortgage options, you should consult a professional (like…me!).
Down Payments and Debt-to-Income ratios are the most significant determining factors in purchasing real estate. However, since there are a fair amount of low-to-no down payment mortgage options (and I will likely have a down-payment blog post in the near future), I’m going to focus on Debt-to-Income ratios.
Debt-to-Income Ratios (DTIs)
Your DTI is the ratio of your monthly debt payments to your gross pre-tax monthly income (debt payment divided by income), normally expressed as a percentage.
A simple example: if you have a $1200 mortgage payment and a $4000 gross monthly income, your DTI would be 30% ($1200/$4000 = 30%). Mortgage underwriters look at two different ratios, called your front and back ratios. Your front ratio is just your mortgage payment (with taxes and insurance and such) divided by your gross monthly income while your back ratio is ALL of your debt payments (including your mortgage payment) divided by your gross monthly income.
To continue our example, let’s you have a $300 car payment in addition to your $1200 mortgage payment (and still make $4000/month). Your front DTI is 30% and your back DTI is 37.5% (($1200+$300)/$4000). These ratios would be expressed as 30%/38% or simply 30/38.
Underwriters don’t want you to have too high of a mortgage payment (or total debt payments) in relation to your income. The higher your DTIs, the less money you have to meet your expenses and the more of a risk you are of not being able to make a mortgage payment. So, underwriters and lenders set limits as to how high your DTIs can be. VA, FHA, USDA, and Conventional loans all have different debt-to-income ratio caps, with FHA being the highest (i.e. they allow for the most debt payments in relation to your income). Since most first-time homebuyers use FHA loans to purchase a home, I’m going to focus on FHA DTI limits and calculations.
As a general rule, FHA allows for DTIs as high as 45/55, meaning they will allow for a mortgage payment as high as 45% of your gross monthly income and total debt payments as high as 55% of your gross monthly income. It’s important to note that for DTI calculations, your entire monthly housing expense is considered (excluding utilities). So, for an FHA loan, they will consider your entire mortgage payment consisting of principal & interest, property taxes, homeowner’s insurance, and mortgage insurance. If you live in a condo or some other association that has HOA fees, those are considered as well.
Now that we have a background on DTIs (FHA DTIs, specifically), it’s actually pretty easy to determine how much of a maximum mortgage payment you can have. If you have no debt aside from the potential mortgage, you simply multiply your gross monthly income by the DTI limit (45% or 0.45). Your $4000 income will support a $1800 monthly mortgage payment. If you have other debts, then the maximum amount of total debt payments you can have per month is $2200 ($4000 x 55%).
Usually, people do have other debts (car loans, student loans, credit cards, etc.) so the back DTI is almost always higher. Both DTIs need to be under the 45/55 limit, so if one is higher, then the proposed mortgage payment needs to be reduced until both DTIs are under the limit.
Let’s say that you had a $4000 monthly gross income and were considering purchasing a house. You also have a $500 monthly car payment, $300 in minimum credit card payments, and $250/month in student loans. Your total debt payments, without a mortgage, are $1050/month, so your current back DTI is already at 26%. Since you can only go as high as 55% (back DTI), we subtract 26% from 55% to determine how much more of your income can go towards a house payment. 55% minus 26% is 29% (29% of your income can go towards a house payment). That 29% times your income of $4000 gives us $1160. The maximum mortgage payment that you can pay each month for an FHA loan, considering your existing income and debts, is $1160.
Notice that your front DTI limit allows for a mortgage payment of $1800 ($4000 * 45%), but you can’t go that high, because any mortgage payment of $1160 would push your back DTI to over 55%.
So, how much home can I buy?
Now for the fun part. Once you've calculated the maximum monthly mortgage payment you can have, you can work backwards to determine how much of a mortgage that would support.
I'm going to give you a quick-and-dirty rule for this, but be warned that this rule makes a TON of assumptions! I'm using estimates for what your interest rate would be, how much your taxes and insurance would be, etc. If your rate ends up being higher or if you buy in an area of higher property taxes, these numbers could be significantly off. Remember, this is just to get you thinking. You would need a full consultation and analysis to really determine the loan amount.
The Quick-and-Dirty Rule for determining your maximum FHA mortgage using rates and assumptions as of when this blog was written is: multiply your maximum allowed mortgage payment by 165.
So, if you can afford a maximum payment of $1160/month, your maximum mortgage will be $191,400.
Again, use that with caution!
But how much should you buy?
Everything I've discussed above is just an overview of how much home you might be able to afford. But how much home should you really buy? I'll go into this in depth in an upcoming blog post, so stay tuned!
