Home ownership is definitely something that’s in my long-term plan, but I haven’t quite figured out where it fits in. One important aspect of determine when I will buy a house, is determining how much house I can afford. I obviously don’t just want to buy a house for the sake of buying a house, so I won’t be buying until what I can afford aligns with what I want.
The eventual approval for a mortgage is a complicated process, but there are some simple calculations that can be performed to get an idea about how much house you can afford. For example, the FHA publishes its loan requirements on its website. Zillow also offers a quick-and-easy calculation of how much house you can afford. But before you rush off to run the calculation, let’s look at these ratios a bit more.
Mortgage Payment to Income Ratio
Under this qualification ratio, the total mortgage payment (including principal, interest, taxes, insurance, amd PMI) is compared to your gross income as a ratio. This is sometimes referred to as a front-end ratio. The FHA states that it requires a minimum front-end ratio of 31%. You might see 28% mentioned as a common ratio required by private lenders (often expressed as 28/36 debt-to-income — the 36 applies to the next ratio).
To calculate this, you multiply your monthly gross income by the required percentage. For example, if you have a gross income of $8,333 (100,000/12), your mortgage payment should not exceed $2,333 (under a 28% ratio).
Total Debt to Income Ratio
This is where your other debt comes into play. This ratio compares your total monthly payment toward servicing debt with your income. Total debt adds auto loan, student loan, and credit card payments. For U.S conforming loans, the maximum ratio is typically 36%. By taking the difference between the two ratios (8%), you can see that your other debt servicing payments can be up to $666 per month.
Calculating Your Affordable Mortgage
Now that you know what type of payment you can afford, you’ll need to convert this into the amount of house you can afford (or qualify for). If we use today’s rates of 3.5% on a 30-year fixed mortgage, you’d owe about $45 per month for each $10,000 borrowed. You’d have to adjust for any PMI required.
Using the above example:
$2,333/45 = 51.84
51.84 x $10,000 = $518,400
So based on this example income and ratios (which mirror mine), I’d be able to qualify for approximately $500,000 worth of house. And then I’d add any down payment made on top of that.
By comparison, if interest rates are at 6%, then you’d use a ratio of approximately $60 per $10,000 borrowed, which would yield a total mortgage of $388,833.
As you can see, just by being able to take advantage of lower interest rates, I’d be able to purchase more than $100,000 more house for the same monthly payment. I know these aren’t the correct terms to think of as far as home purchases go since the higher 6% loan could potentially be refinanced later, but it’s hard to ignore the huge impact that today’s lower interest rates play.
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