When you're ready to buy a home, it can be tempting to jump right in and start your search. Before you do, however, it pays to know exactly what you can afford -- not just what a lender is willing you give you. A savvy buyer will consider affordability before jumping into substantial debt.
Many buyers, especially first time buyers, over-estimate how much they can afford. Use this information to give yourself a payment comfort level so you do not become house poor.
Lenders use something known as front-end ratio, which is a percentage of your gross (before-tax) monthly income. The front-end ratio signifies the payments you can reasonably afford, according to the lender, but you may want a lower payment.
For an FHA loan, the front-end ratio is 31%. If you get a conforming conventional loan, the ratio is 33%. If you make $4,000 per month gross, your monthly principle, interest, taxes and insurance (PITI) payment cannot be more than $1,240 for an FHA loan or $1,320 for a conventional loan.
The back-end ratio, on the other hand, is your new monthly mortgage payment plus recurring debts, and it is based on your gross monthly income as well. The back-end will be higher: 43% for an FHA loan and 45% for a conventional loan.
Your back-end ratio will take into account credit card payments, car payments, student loan payments and any other recurring debts you have. If you have a car payment of $300 and a $100 minimum monthly payment on two credit cards, you have $400 in recurring monthly debt.
If you want to qualify for an FHA loan, for example, your payment above of $1,240 would be added to the $400 in recurring debt for a total of $1,640. Because the back-end ratio is $1,720 ($4,000 x 43%), and your total monthly debt is lower, you will qualify.
With this information, you know how much of a mortgage payment you qualify for, and you can determine how this translates into a sales price.
Your home loan amount will depend on the interest rate you receive. Interest rates change daily. If you want to get a mortgage with a $1,000 payment, you can borrow $170,000 at 6% interest on a 30-year fixed-rate loan. Your principal and interest at these terms will be $1,019 per month.
If you get a 7% interest rate, however, you can only afford to borrow $150,000, with a payment of $998 per month. Just a one percent difference will cause you to lose $20,000 in borrowing power.
Your down payment amount will depend on many things. How much
are you comfortable putting down on a home? It is usually wise to keep a reserve in savings.
Do not be afraid to borrow less than the amount shown on your loan preapproval letter. If you feel more comfortable borrowing less, shop around for homes that meet your budget. If you make the mistake of taking out a loan that will be hard to maintain, you will be putting a hard burden on yourself for years to come.