Lots of home buyers, especially those in California, over estimate how much home they can afford. For example, a $250,000 home in California might be a starter home, but it still costs a quarter of a million dollars!
First, look at your monthly gross income, before taxes and contributions. This is how much you make per month, not how much you take home. What you take home is net income.
- Front-End Ratios
Lenders use what is called a front-end ratio, which is reflected as a percentage of your gross monthly income. The front-end ratio signifies the payment a buyer can reasonably afford, from a lender's point of view. You may prefer a lower payment.
The front-end ratio for a FHA loan is 31%. For a conforming conventional loan, the front-end ratio is 33%. This means if your monthly gross income is $4,000, to qualify for the maximum FHA loan, your monthly principal, interest, taxes and insurance (PITI) payment can not exceed $1,240. For a conventional loan, it is $1,320.
- Back-End Ratios
The back-end ratio reflects your new mortgage payment, plus all recurring debt. It, too, is computed on your gross monthly income. The back-end is higher than the front-end. For an FHA loan, the back-end ratio is 43%. For a conforming conventional loan, it is 45%.
This means if your car payment is $300, and you pay $100 a month between two credit cards, your total monthly recurring debt is $400. On the FHA loan payment above of $1,240 PITI, plus $400 recurring debt, your total is $1,640. The back-end ratio number is $1,720 ($4,000 x 43% = $1,720). Your total debt is less than $1,720, so you qualify.
For a conventional loan, $4,000 x 45% (back-end ratio), equals $1,800. The total debt of $400, plus your new mortgage payment of $1,320 for a conventional loan equals $1,720. Your total debt is less than $1,800, so you would qualify for a conventional loan.
Home Sales Price Affordability
Working backward, now that you know how much of a mortgage payment you qualify to pay, you can figure out how that relates to a sales price. You will hear experts say to pay anywhere from two to six times your annual salary, but it is smarter to look at the amount of mortgage you can get for that monthly payment.
Your mortgage amount will depend on interest rates. Interest rates fluctuate daily, sometimes hourly. For example, say you want to pay $1,000 per month PI. At 6% interest, on a 30-year fixed-rate mortgage, you can borrow $170,000, payable $1,019 per month.
At 7% interest, you can borrow only $150,000, payable at $998 per month. In this example, you lose $20,000 of borrowing power when the rate jumps from 6% to 7%.
Down payment amounts will depend on several factors. First, how much do you feel comfortable putting down? I suggest that first-time home buyers keep a healthy reserve and not dump every single cent into a home.
- No Down Payment
If you qualify for 100% financing, your down payment will be zero. VA loans are available for veterans at no-money-down. Some first-time home buyers programs accept borrowers with limited funds for gift down payment programs, providing certain income limits are met. If you make too much money, you will not qualify.
- FHA Down Payments
Minimum FHA down payments are presently 3.5% of the sales price. To borrow $150,000, your sales price will be $155,440, and your down payment is $5,440. Legislation is pending to lower that percentage. Some first-time home buyer programs, used in conjunction with FHA, help with the down payment.
- Conventional Loan Down Payments
Any loan that is more than 80% of the sales price will involve PMI, private mortgage insurance, which will increase your monthly mortgage payment. Typical down payments are 5%, 10% or 15% of the sales price. If you plan to put down 5% of the sales price and borrow $150,000, your sales price will be $157,900 and your down payment $7,900.
- Closing Costs
Sometimes, sellers will pay some or all of the buyer's closing costs. You can figure 2% to 3% of the sales price will equal your closing costs. On a sales price of $150,000, your closing costs could run $4,500, which is extra and on top of your down payment.
Your Payment Comfort Level
Before you jump into home ownership, why not set aside the additional amount you would pay for a mortgage every month to see how you do? For example, if your rent is $800 and you plan to pay $1,200 for a PITI payment, set aside $400 per month for three to six months.
In other words, pretend you are paying a mortgage payment. If $1,200 a month doesn't strap you for cash, you can probably afford to pay that much for a mortgage payment.
If you feel more comfortable borrowing less than the amount shown your loan preapproval letter, then do so. Don't make the mistake of taking out a mortgage that will be a struggle for you to maintain. Do what feels right to you.
A dream home can usually wait. You probably don't need to buy the most expensive home you are qualified to buy. Consider a starter home as your first home. Work first on building equity and security for yourself and your family.
At the time of writing, Elizabeth Weintraub, DRE # 00697006, is a Broker-Associate at Lyon Real Estate in Sacramento, California.