As with most decisions when buying a house, figuring out how much house you can afford is half financial and half psychological. My goal as a real estate agent is to see you deliriously happy after buying a house and how happy you are after your purchase depends on how well you balance the two. This is part one of a two part article on how much house you can afford.
Part 1: The Financial Half
How much of a house you can afford financially boils down to convincing your lender to let you borrow enough money to purchase the house. Most lenders will lend you what you need if they can answer "yes" to three basic questions:
1. Can you pay back the mortgage?
2. Will you pay back the mortgage?
3. Do you value paying back the mortgage?
"Can you pay back the mortgage?"
Lenders answer this question using your income compared to how much you owe others. This comparison is called your debt-to-income ratio; it is your income before taxes divided by your liabilities.
So, for example, if you owe $1,000 per month and earn $5,000 per month, your debt-to-income ratio is 20%. If you have no debt, your debt-to-income ratio is zero.
Lenders have a general rule that your debt-to-income ratio should not exceed more than 36% of your income. The debt they use includes the mortgage you are applying for, your car loan, student loans, credit card balances, and any money you owe other institutions.
There are a number of debt-to-income calculators on the Internet. If you are looking to purchase a house, a good way to increase your chances of getting a quality mortgage is to pay off debt (without canceling or closing your lines of credit).
Most lenders use another rule as well: that no more than around 40%, sometimes even 50%, of your gross income, how much you make before taxes, should go towards paying for your house and the expenses associated with it. This combination of principal, interest, taxes and insurance is known as PITI.
I strongly believe, though, that your comfort level is more important than the amount the lender will let you borrow. After all, their incentive is to earn interest on as large a loan as possible. My goal is your delirious happiness.
If we run the numbers and you believe your PITI exceeds what you're comfortable spending each month, you have a few options to play with: lowering your mortgage payments, increasing your income, finding a less expensive house, or waiting on your home purchase until you can make a larger down payment.
"Will you pay back the mortgage?"
Lenders use your credit score to decide the answer to whether you will pay back the mortgage. While a number of companies have devised ways to calculate your credit rating, only one matters: your FICO score.
When applying for a mortgage, your FICO score is the primary factor in whether you qualify and how much you will pay in fees and interest. It's a number between 300 and 850 and is meant to be a quick illustration of how likely you are to pay your bills on time, if at all.
In general, if your FICO score is above 720, you will have flexibility in what loans you can ask for and may qualify for a discount, and if your score is above 800, you have considerable bargaining power. But if your FICO score is 680 or below, mortgages will be more expensive and much more difficult to get.
"Do you value paying back your mortgage?"
Lenders infer how much you value paying back your mortgage by how much of a down payment you provide. Down payments are paid as cash upfront. If you stop paying your mortgage, you "lose" your down payment when the lender forecloses on the house. How much you should put down depends on your situation.
Your lender will usually allow you to make a smaller than 20% down payment, either through a "piggy-back" loan or PMI, which can give you more financial flexibility.
If you put down 20% or more of the house's purchase price as a down payment, they will generally start you off with their lower mortgage rates. If you don't put anything down, they will generally impose additional fees.
Bottom line: Lenders need to answer "yes" to all three questions before you can get a mortgage.