How much of a mortgage can you comfortably handle?
You're tired of renting and you've decided that you want to buy a house. The bank has told you that you qualify to buy a home for $300,000. Can you rely on this as the gospel truth? What if the furnace breaks or the roof springs a massive leak? Can you afford to fix it and make your mortgage payment, too? How can you be sure you don't get in over your head?
They're all sensible, logical questions. Lots of homebuyers overestimate how much they can really afford. You can realistically calculate how much home your income and budget can accommodate when you understand all the terms involved and how they affect your buying power.
First, look at your monthly gross income. That's your income before taxes and things like retirement contributions are deducted. This is how much you make per month, not how much you take home. Use this number to calculate two ratios.
Lenders use what is called a front-end ratio, which is reflected as a percentage of your gross monthly income, to determine how much loan you can qualify for. The front-end ratio indicates the payment you can reasonably afford from the lender's point of view, although this isn't to say that you wouldn't prefer a lower payment.
The front-end ratio for an FHA loan is 31 percent as of 2017. For a conventional loan, the front-end ratio is 28 percent. This means that if your monthly gross income is $4,000, your monthly principal, interest, taxes, and insurance payment, called PITI, can't exceed 31 percent of $4,000, or $1,240. It comes out to $1,120 PITI for a conventional loan.
The back-end ratio reflects your new mortgage payment plus all your recurring debt. It, too, is computed on your gross monthly income. The back-end ratio is always higher than the front-end ratio. The back-end ratio is 43 percent as of 2017 for an FHA loan and 36 percent for a conventional loan.
This means that if your car payment is $300 and you pay $100 a month between two credit cards, your total monthly recurring debt is $400. Your total debt would be $1,640 including an FHA loan payment of $1,240 PITI and that $400 in recurring deb. The back-end ratio number is $1,720, or 43 percent of $4,000. Your total debt is less than $1,720 so you would qualify.
For a conventional loan, multiply $4,000 by 36 percent to arrive at $1,440. Your total debt of $400 plus your new mortgage payment of $1,120 for a conventional loan equals $1,520. That's more than the back-end ratio of $1,440, so you might not qualify for a conventional loan.
Now that you know how much of a mortgage payment you're likely to qualify for, you can figure out how that relates to the sales price. You'll hear experts say that you should pay anywhere from two to six times your annual salary, but it's smarter to look at the amount of mortgage you can get for the monthly payment you can afford.
Your mortgage amount will depend a great deal on interest rates. Interest rates fluctuate daily, sometimes hourly. Say you want to pay $1,000 per month PI. At 6 percent interest on a 30-year fixed-rate mortgage, you can borrow $170,000, payable at $1,019 per month.
At 7 percent interest, however, you can only borrow $150,000, payable at $998 per month. In this example, you lose $20,000 of borrowing power when the rate jumps from 6 to 7 percent.
Down payment amounts depend on several factors. First, how much do you feel comfortable putting down? It's often suggested that first-time home buyers keep a healthy reserve and not dump every single cent they have into the down payment on a home.
If you qualify for 100-percent financing, your down payment will be zero. VA loans are available for veterans at no-money-down. Some first-time home buyer programs accept borrowers with limited funds for gift down payment programs, providing they can meet certain income limits. You won't qualify if you earn too much money.
Minimum FHA down payments are 3.5 percent of the sales price as of 2017. Your sales price would be $155,440 and your down payment would be $5,440 if you borrowed $150,000. Some first-time home buyer programs help with the down payment when they're used in conjunction with FHA.
Any loan that is more than 80 percent of the sales price will require PMI or private mortgage insurance, and this will increase your monthly mortgage payment. Typical down payments are 5 percent, 10 percent, or 15 percent of the sales price. If you plan to put down 5 percent and borrow $150,000, your sales price would be $157,900 and your down payment would be $7,900.
Then there are closing costs. Sellers will sometimes pay some or all of a buyer's closing costs, but you can figure that they will add up to 2 to 3 percent of the sales price. On a sales price of $150,000, your closing costs could run about $4,500 on a sales price of $150,000, which is extra and on top of your down payment.
Before you jump into homeownership, why not set aside the additional amount you would pay for a mortgage every month to see how you do? For example, if your rent is $800 and you plan to pay $1,200 for a PITI payment, set aside $400 per month for three to six months. In other words, pretend that you're making a mortgage payment. If $1,200 a month doesn't strap you for cash, you can probably afford that much for a mortgage payment.
If you feel more comfortable borrowing less than the amount shown your loan preapproval letter, then do so. Don't make the mistake of taking out a mortgage that will be a struggle for you to maintain. Do what feels right.
A dream home can usually wait. You probably don't need to buy the most expensive home you're qualified to buy. Consider a starter home as your first home. Work first on building equity and security for yourself and your family.