Home ownership remains a key part of the American Dream. Whether it’s a suburban ranch, an urban brownstone, or a country mansion (hey, we can dream!), buying a home is what you do when you want to put down roots.
As exciting as shopping for a new home may be, most of us don’t have the means to buy a house outright. To get around this, you’ll need someone to give you a loan. But how much of a loan can you get? And what factors go into determining that? That’s what we’ll explore in today’s article, which is all about how you (and lenders) determine how much house you can afford.
Principal, Interest, Property Taxes, and Insurance (PITI)
When we ask the question, “How much house can I afford?”, what we’re really asking is, “How much house does a mortgage lender think I can afford?” Lenders base how much money they’re willing to lend you on something called the debt-to-income ratio. What exactly is that? It’s the result of some simple math.
The first part of calculating your debt-to-income ratio comes from what’s known in the mortgage industry as PITI. This stands for Principal on mortgage, Interest on mortgage, Property Taxes, and mortgage Insurance. The sum of these (along with HOA or condo fees) is your monthly housing cost.
In general, lenders will consider you a safe borrower (that is, one who is unlikely to default) if no more than 28% of your gross monthly income is going toward paying your housing expenses. In the mortgage industry, this is known as the front-end ratio. So, for example, if you bring home $4,000 per month, then you’ll want your PITI to be no higher than $1,120 in order for mortgage lenders to consider you a safe borrower.
In practice, however, PITI isn’t the only thing lenders use to determine your eligibility for a mortgage. In addition to your monthly mortgage payment and other housing expenses, they’re also interested in your total debt. Specifically, in the ratio of your gross monthly income to your monthly debt payments.
These monthly debt payments include PITI, but they also include other debt such as credit card payments, car payments, student loan payments, child support payments, alimony payments, and other personal loans.
In order to get a mortgage, the ratio of your total debt (PITI and all other debt payments) to gross income needs to be 36%. Mortgage lenders call this the back-end ratio. So, for example, if your gross monthly income is $4,000, then your total monthly debt payments need to be less than $1,440 in order to make you a good mortgage candidate.
Understanding the front-end and back-end ratios will help you figure out not only how much of a mortgage you can qualify for, but also how much you need to increase your annual income or decrease your debt if you’re unhappy with the current mortgages available to you.
Your Credit Score: The Other Key Factor
The front-end and back-end ratios are an important part of how much house you can afford, but they’re not the only factor that matters. Another crucial factor that lenders consider is your credit score. This number has an effect on not only how much lenders will allow you to borrow, but also on your mortgage interest rate.
A full discussion of credit scores is beyond the scope of this article, but we’ll cover the basics as relevant to qualifying for the most favorable mortgage terms possible.
The first thing to understand is that there is no specific credit score for getting the best mortgage. A higher score is always better, but it’s up to the individual lender to decide what scores will merit a given interest rate. Assuming your lender uses a FICO score model, then you want your score to be as close to 750 as possible (higher if you can). This is an “excellent” credit score and is most likely to guarantee you the lowest mortgage rates. In the long term, a lower interest rate translates into a lower monthly payment.
If you’re in the market for a mortgage, then we suggest that you don’t open any new lines of credit. While recent “hard” credit inquiries (inquiries made when you are applying for a new line of credit) only make up 10% of your FICO credit score, too many of them can be detrimental.
Furthermore, we also recommend paying down your existing credit card debt, as this can lower your overall debt burden (a factor that makes up 30% of your FICO credit score). Not only can this raise your credit score, but it can also decrease your overall monthly debt payments, which means a more favorable back-end ratio.
In order to improve your credit score, you need to know what it is. Luckily, US law gives you a right to know this information for free. As the FTC explains, “The Fair Credit Reporting Act (FCRA) requires each of the nationwide credit reporting companies — Equifax, Experian, and TransUnion — to provide you with a free copy of your credit report, at your request, once every 12 months.” To get this information, visit AnnualCreditReport.com.
While you can get your credit score other ways (many credit card companies allow cardholders to view their score online), don’t trust any other sites that promise you a “free” credit score. Many of these companies are out to spam you, and some are out to steal your financial information. AnnualCreditReport.com is the official, FTC-authorized source.
Home Affordability Calculators
While the math we have discussed in this article is not difficult, it can get tedious to run the same calculations over and over again, especially if you have different kinds of debt or want to compare different mortgage amount options. To make your life easier, we recommend the following mortgage calculators from across the internet:
- How Much House Can I Afford? – Bankrate
- How Much House Can I Afford? – NerdWallet
- Affordability Calculator – Trulia
You can also speak to a certified financial planner if you have further questions.
Happy House Hunting
Buying a house is an exciting process, but it can also be confusing. Now that you’ve read this article, we hope that you’re no longer confused about some of the key financial calculations that go into the home buying process. With the knowledge of how much house you can afford in mind, you can turn you attention to the fun parts: Tudor or Craftsman, city or suburbs, finished or unfinished basement?
Once you’ve bought a house, you’ll need to pay property taxes on it. Wouldn’t it be great if there were an easy way to calculate and file those taxes? As it turns out, there is. Today’s tax preparation software allows you to calculate and file your property taxes, leaving you with more time to enjoy your sweet pad.
We’ve made it easy to find the best tax preparation software for your needs with our tax software reviews and comparisons. You can also sign up for our email newsletter to receive weekly tax tips straight to your inbox.
Thanks for reading, and happy house hunting!