You've decided you want to buy a home, but before you start looking, you need to look at your finances so you don't fall in love with a home you can't afford. Unless you're planning on paying cash, you need to begin by looking at your monthly income to calculate how much you can spend on a mortgage.
Once you know the amount you can put toward your housing costs each month, you can figure the maximum amount of house you can afford. Lenders look at two main ratios: the front-end ratio, which measures just your mortgage-related expenses compared to your pretax income, and the back-end ratio, which measures all of your debt payment compared to your pretax income.
Calculate Front-End and Back-End Ratios
Multiply your pretax monthly income by the the front-end ratio. Typically, lenders will not let your front-end ratio exceed between 28 and 33 percent. For example, if your pretax income is $5,300, and you can afford to spend 33 percent of your income on mortgage-related expenses, multiply $5,300 by 0.33 to get $1,749.
Multiply your pretax monthly income by the maximum back-end ratio permitted by your lender. Most lenders do not want your back-end ratio to exceed 36 percent. Continuing the example, multiply $5,300 by 0.36 to get $1,908.
Figure in Loan Payments
Add up any other loan payments you have to make each month. For example, if you have a $250 student loan payment and a $100 car loan payment, your other monthly loan payments total $350.
Subtract your other monthly loan payments from your back-end ratio amount to figure the maximum mortgage payment under the back-end ratio. In this example, subtract $350 from $1,908 to get $1,558.
Calculate Your Monthly Budget
Use the smaller of your front-end ratio or your back-end ratio minus loan payments to determine how much you can afford to spend each month on your housing costs. In this example, the back-end ratio of $1,558 is smaller.
Subtract from the smaller of the two ratios the amount you expect to have to pay in homeowner's insurance and property taxes. For example, if you estimate your monthly real estate costs to be $240, and your monthly homeowner's cost is $60, your housing cost monthly budget drops from $1,558 to $1,258.
These prices can vary based on location and the value of your home, even within the same region. However, a real estate broker or insurance agent should be able to provide a range within the area you are looking.
Determine Maximum Mortgage
Add between 0.5 and 1 percent to your anticipated interest rate if you cannot make a down payment of at least 20 percent on your house, to account for private mortgage insurance. For example, if you expect a 4 percent interest rate on your mortgage, add 1 to 4 to get 5 percent. Lenders require this insurance to protect them against losses if your home loses value, and you default on the loan. If you can afford a 20 percent down payment, skip this step.
Use a financial calculator to calculate the maximum amount you can afford to borrow by entering the housing budget amount, the term of your mortgage and your estimated interest rate. For example, a $1,258 monthly payment with a 5 percent interest rate over 30 years gives you a maximum mortgage of $234,342.27.
Add the amount you can afford to pay as a down payment to the maximum mortgage amount to figure the most expensive home you can afford. For example, if you have $50,000 saved up to use as down payment, add $50,000 to $234,342.27 to find that the most expensive home you could buy would be $284,342.27.
If you are single with no children and can afford to spend a larger percentage of your current income, you may be able to afford the high end of the front-end ratio range. If you are married with young children and want to have one spouse not work, a lower percentage is probably better, even if your lender allows you to borrow more.
Don't forget to consider the cost of changes and updates. A brand-new home may be in move-in condition. However, with a preowned home, factor in the cost of painting, new carpets, appliances or anything else you, personally, might require to make it more livable.
- If you are single with no kids and can afford to spend a larger percentage of your current income, you may be able to afford the high end of the front-end ratio range. If you are married with young children and want to have one spouse not work, a lower percentage is probably better, even if your lender allows you to borrow more.
- Don't forget to consider the cost of changes and updates. A band-new home may be in move-in condition. However, with a pre-owned home, factor in the cost of painting, new carpets, appliances or anything else you, personally, might require to make it more livable.