If you’re searching for a new home, you’ve certainly noticed the current state of the housing market. The cost of housing has gone up considerably, but it’s important to realize how much house you can afford realistically so that the home does not become a financial burden to you. For some people, once they crunch the numbers, they realize they’re not ready to be homeowners—and that’s fine. It’s better to delay it because you’re not financially ready than to rush into it and make a costly mistake.
Here are two numbers you should know beforehand:
- The front-end ratio, also known as the housing ratio, looks at PITI (principal, interest, taxes, and insurance) and is considered your total house payment. It compares PITI as an annual figure against your gross annual income. Many mortgage lenders don’t want to see annual PITI surpass 25-29 percent of your annual income. For example, if you and your spouse make $72,000 a year combined and the mortgage company looked at that with a 28% front-end ratio, you could qualify for a mortgage with an annual cost of no more than $20,160 (72,000 x .28). Divide that by 12, and your monthly house payment should not exceed $1,680.
- The back-end ratio is also known as the debt-to-income ratio. This looks at PITI as well as all other debts (car loan, student loan, credit card debt, etc.). Divide your monthly debt payments (including future house payment) by your gross monthly income and multiply by 100. Mortgage companies prefer a ratio of 36% or less. If you make $6000 a month ($72,000/yr) and apply a 36% ratio, then your total monthly debt payments, including the house, should not total $2,160 (6000 x .36). If you’re paying $500 in cars and $500 in student loans, you can easily see how debts can limit your housing options.
Some lenders will accept higher ratios if you have a high credit score or a strong down payment. However, it’s more important that you get into a home that you can afford that gives you some breathing room each month for other essentials as well as discretionary spending. If you can’t increase your income, then pay off as much debt as you can before taking on a mortgage.
In the meantime, if you’re renting, remember the 40x rule when finding something affordable. This means that your gross annual income should be at least 40 times the monthly rent. If you make $45,000 a year, divide that by 40, and your monthly rent should not exceed $1,125.