October 26, 2021
5 MINUTE READ
Your home is usually the biggest financial purchase you would make, so figuring out how much home you can really afford is a crucial step in the homebuying process. Fortunately, coming up with a smart budget strategy is pretty straightforward, and can make your home buying process much less stressful.
To calculate how much home you can afford, you’ll take into account a few key pieces of information, like your total household income (including all revenue streams), monthly debts (auto loans, student loans, etc) and how much you have saved to comfortably put toward a down payment. As a homebuyer, and especially as a first time homebuyer, you’ll want to be comfortable and confident in understanding your monthly mortgage payments.
While some of these numbers remain relatively stable, such as your monthly income and expenses, it’s important to remember that there are a number of emergency situations or unforeseen circumstances that can affect your savings.
A good rule of thumb for home affordability is to have at least three months of payments, including your monthly mortgage payment and other monthly debts, in reserve in your savings. This allows you to still comfortably afford your home for a while, in the event that something unexpected comes up.
To take the above metric a step further, the 28/36 rule states that you should spend no more than 28% of your gross monthly income on housing expenses, but also that you should spend no more than 36% of your gross monthly income on all monthly debts, including credit cards, child support (if applicable), auto loans, and more.
If taking out a mortgage causes you to spend more than 28% of your gross monthly income on housing expenses, or the mortgage would make you spend more than 36% of your gross monthly income on total monthly debt payments, you may be at higher risk of running into financial troubles in the future.
Keep in mind that you may still get approved for the amount you’re hoping to borrow, and at a decent interest rate, even if your metrics are a little higher. Many lenders will still approve you for a mortgage, even if the mortgage would put you into more debt than you’d like. The important thing to remember is that you are the one taking on this debt — yes, buying a home is exciting, but it should also provide a sense of financial stability.
You’ve likely heard your lender use the term front-end ratio — but do you know what that means? This is the ratio of your monthly housing expenses to your gross monthly income, and following the 28/36 rule, the goal is for this number to be at or below 28%.
Keep in mind, however, that the front-end ratio doesn’t only refer to your monthly mortgage payment. It also includes several other components:
Let’s look at an example. Your gross income is $10,000 per month. Each month, you pay $2,000 toward the principal and interest on your mortgage, $300 toward your property taxes, $200 in homeowners insurance, and $100 in HOA dues. When you add this together, you are paying $2,600 each month toward your home. Divide $2,600 by $10,000 for a total of 0.26. This means that your front-end ratio is 26%, which is less than the recommended ratio of 28%.
You’ve probably also heard the term back-end ratio when going through the home buying process. This may also be referred to as your debt-to-income, or DTI, ratio. This is the ratio of your total monthly debt payments to your gross monthly income. The 28/36 rule says that in addition to your front-end ratio being 28% or less, you also want your back-end ratio to be 36% or less.
It’s extremely important to understand the back-end ratio, because even if your front-end ratio is less than 28%, you may have other monthly debt commitments that could make you a higher risk when it comes to mortgage lending.
The back-end ratio includes your housing payments along with your other monthly payments, including credit cards, auto loans, student loans, personal loans or lines of credit, alimony and/or child support (if applicable), and more.
Let’s go back to the example above. If you’re paying $2,600 each month toward your home, and you’re also paying $400 toward your credit cards, and $500 toward your auto loan. Now, your monthly debt is $3,500. Divide this number by your $10,000 gross monthly income and you get 0.35. In other words, your back-end ratio is 35%. In this scenario, you should be able to comfortably and securely afford this home.
Of course, as with any rule, there are always exceptions. If you have too much monthly debt to pass this test, don’t give up on your dream home just yet.
Your lender may still approve your application if other parts of your credit profile are stellar. For instance, maybe you have an excellent credit score, demonstrating a history of solid and responsible use of credit and management of funds.
Maybe you have more than the standard 20% to put toward a down payment. You may also still be approved with higher debt ratios, but keep in mind that you may pay a higher interest rate than you would if you had less debt. It pays to put in some work to lower your debt and improve your credit score before you begin shopping for a home.