How Much House Can You Afford?
For most folks, buying a home is the most major investment of their lives. And if weve learned anything from the recent round of foreclosures and other trouble on the credit front, its not a purchase that allows overly optimistic views of personal finances or tolerance for those who havent taken time to read the fine print.
Squirreling away cash for a respectable down payment is just the beginning of the planning process. Several other components and considerations are involved, so heres an introduction to help you shop in the right direction.
Critical calculations and what they mean
Your income, debt and assets are all in play when it comes to determining how much house you can afford. Several online calculators exist that can give you an idea of how formulas operate, but when you sit down with a professional mortgage broker or lender to do the real work, theyll be helping you to calculate two numbers critical to qualification for a loan: a front-end ratio and a back-end ratio, each based on a percentage of your gross monthly income. The front-end ratio represents how much of your income is spent on monthly housing expenses, such as mortgage principal and interest, taxes and insurance. The back-end ratio represents your monthly debt spending, including auto loans, student loans, child support payments and credit cards. So, as an example, with a ratio tally of 28/36, 28 stands for 28% of gross monthly income devoted to front-end spending, and 36 stands for 36% of that same income spent on back-end costs.
What your mortgage broker needs from you
In order to calculate front-end and back-end ratios properly and find the best lending fit for your means, a mortgage professional will be doing some very thorough, very personal info gathering while looking into your not-so-distant future.
Everyones different, so what I do is meet with the customer face-to-face the first time, just to get as much information as I can, says Ken Gunther, president of First Interstate Financial Corp., a mortgage banking group based in Shrewsbury, New Jersey. I ask them a lot of questions, like where they think theyre going to be in five years─is something going to change? In other words, will there be a job promotion, or are they getting married? You try to get as much information as possible so that you can steer them toward the right loan for them.
Youll also need to be prepared with hard numbers for the following items:
- Your credit score, preferably in report form so that you can check for and correct any errors
- Your gross income
- Current records for all financial accounts (checking, savings, money market, etc.)
- Amount of monthly debt
- Information on long-term investments and reserves, including retirement accounts and owned properties
- Information on the source of funds to be used for a down payment, whether contained in an existing account or to be received as a gift from a family member
All of the above must be current, valid and based in the now, because inflated numbers can end up bringing down the roof later. Says Gunther, Someone may say, Im making $70,000 a year, and then you find out that theyre really making $50,000, but theyre anticipating a year-end bonus of $20,000 more that theyve never received in the past So, although theyre going to get the bonus, we cant use it in the calculations because, technically, they havent received it.
Similar specifics apply to debt payments, another possible point of confusion in the info-gathering process.
An applicant may say, I have this loan or I have this charge card, and again, we just have to make sure theyre accurate in what theyre reporting on that, adds Gunther. They may quote their minimum monthly payment as $300, while their credit report says its only $75. Theyre saying $300 because thats what they choose to pay every month, but thats not what we would count against them. We would only count the $75 according to the credit report information.
Knowing your own tolerance for risk
Beyond this important and exhaustive exercise, you also need to be thinking about all of the standard and sometime surprise costs that home ownership entails. As well as taxes and insurance, theres the factor of contributions to a cash reserve thatll be ready to cover emergency repairs and seasonal needs. How much that reserve contains will depend on the age and condition of the home youre hoping to buy, and this is where a thorough, professional home inspection is critical. A deal on a fixer-upper may not be so hot if the after-purchase costs to make and keep it livable are beyond your means, so know what you can live with and stick to it. Youll then be able to enjoy the right home when it comes along, without becoming house-poor or struggling with a case of buyers remorse.
Tom Kraeutler is the Home Improvement Editor for AOL and host of The Money Pit, a nationally syndicated home improvement radio program. To find a local radio station, download the show's podcast or sign-up for Tom's free weekly e-newsletter, visit the program's website.