How Much Can You Afford for a Mortgage?

Diana Brodman Summers, Attorney at Law

Adapted from How to Buy Your First Home (2nd edition) by Diana Brodman Summers ©2003

Every lender has a formula to tell how much a person can afford in mortgage payments. Formulas are good because they can give a definitive number. However, most formulas do not factor in a person's lifestyle (what is important to that person), future financial down-turns, or what each person feels comfortable paying for housing.

COMMON DEBT-TO-INCOME RATIOS
Mortgage lenders loan money based on a set of criteria. That criteria rates the property, the neighborhood, the building, and the borrower. This chapter will explore the common criteria used to rate the borrower and how you can use that information to make decisions before you ask for a mortgage.

Housing-to-Income Ratio
Lenders usually use a two-part ratio calculation that sets the boundaries of what you can pay for a home. This is currently expressed as the 28/36 formula (but the exact numbers may change by the time you read this).

The first part, the front-end ratio or the housing-to-income ratio, is the total mortgage payment divided by your gross monthly income. The percentage result should be somewhere in the 28% to 33% range. Right now 28% is currently used by the majority
of lenders. Depending on your credit history, amount of debts, and amount of potential future income, your lender may change the front end percentage.

The total mortgage payment or housing costs includes: monthly loan payment, real estate taxes, home owners insurance, mortgage insurance (if any), and association fees (if any).

Gross monthly income is what you receive each month from every source. This income total is before taxes or any deductions (such as deductions for your 401(k) program) are taken out.

Debt-to-Income Ratio
The second part, back-end ratio or total debts ratio is the percentage of your gross income that can go towards all of your monthly debt. In the 28/36 formula, a person should not pay more than 36% of his or her monthly gross income for all debts.

Again, gross monthly income is what you receive each month from every source. This income total is before taxes or any deductions (such as deductions for your 401(k) program) are taken out.

Monthly debt includes payments on credit card debts, loans, alimony, child support, plus housing costs, but does not include household expenses like utilities, food, clothing, and the like.

Monthly housing costs are mortgage payment, real estate taxes, home insurance, mortgage insurance, and association fees.

HOW TO USE THESE RATIOS
So, you are probably looking at these ratios and saying "How does that affect me? All I want to do is to get a mortgage without the hassle of dealing with math equations." Not only do I understand, I feel exactly the same. These ratios were created and are routinely
used by lenders, you know, those people who enjoy working with numbers. For the rest of us, these ratios can give us an approximation of what we can afford in a mortgage and for our total debt.

While we can use the ratios like the lenders (as guidelines and generalities to determine if someone qualifies for a mortgage loan), there are two important pieces of information on ratios. First?the ratios can vary by lender, by type of mortgage, and by what the economy is doing. Second?lenders do not only use these numbers. Other factors such as your credit history, the size of your down payment, the cost of the home, the appraised value of the home, and other facts about you and the property go into the decision to issue a mortgage.

This can be better explained through examples. Let's follow two potential home buyers as they wade through the ratios. (We will also see how numbers can be deceiving.)

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Example 1:
Janet is single. She works as a computer programmer making $42,000 per year. Her gross monthly income is $3,500.

According to the 28/36 formula:
Gross monthly income x 0.28 = Total monthly housing expense
$3,500 x 0.28 = $980

Or, in words, Janet can afford a $980 total monthly housing expense. (Remember that total monthly housing expense includes the mortgage payment, plus homeowners insurance, plus real estate taxes, plus any mortgage insurance payments or association payments.)

Looking at Janet's debts:
Gross monthly income x 0.36 = Total monthly debt expense
$3,500 x 0.36 = $1,260

This shows that Janet's total monthly debts should not exceed $1,260. Again, remember that this does not include those pricey household expenses such as utilities, food, clothing, transportation, and other living expenses.

Looking at Janet's monthly debt, she is paying $150 a month on credit card bills and $100 a month on a student loan. If you add the $980 of a total mortgage payment plus the $250 a month on debts, Janet comes up with a total of $1,230 in obligations. This is $30 less than the maximum debt obligation that the 28/36 ratio allows.

So Janet should be approved to get a mortgage from the lender that uses this ratio. Or should she? The numbers look great, but what if the credit history is not so good? Janet's employment history may be spotty. She may have had several jobs in the past 15 years, never staying longer than two years at each job. Janet's employer may have publicly announced that they are closing. So, Janet may not automatically get the mortgage loan she wanted.

What if Janet's credit worthiness is ok, but the property she wants has problems? Maybe the house is in terrible condition and did not appraise for the amount she is asking the bank to loan her? Janet may not be able to get the mortgage she wanted on that property.
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These two scenarios show that although a person can be within the 28/36 ratio, there may still be problems obtaining a mortgage. In both of these cases, Janet may have to provide a larger down payment or she may have to select another property. On the other hand Janet, like many of us, may not feel comfortable with a $980 monthly mortgage payment. She may be planning to buy a new car, plus a house full of new furniture.

So how does the 28/36 ratio relate to real life? These numbers are merely maximums. This ratio says that Janet should not take on a total mortgage payment of more than $980 and that she should not have total debt of more than $1,260. So, if Janet can come up with a sizable down payment, or look for a house with a lower total cost, she may be able to get that total monthly mortgage payment down to around $600. This would allow her to go into more debt on other items.

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Example #2:
Don and Cheryl are newly married; they have no children. Don is a manager at a major insurance company and makes $80,000 per year. Cheryl is a lab technician with an annual salary of $28,000.

Their gross monthly income is $9,000.
According to the 28/36 formula:
Gross monthly income x 0.28 = Total monthly housing expense
$9,000 x 0.28 = $2,520

Don and Cheryl can afford a total monthly housing expense of $2,520. (Again, remember that total monthly housing expense includes, the mortgage payment, plus homeowners insurance, plus real estate taxes, plus any mortgage insurance payments or association payments.

As for debts:
Gross monthly income x 0.36 = Total monthly debt expense
$9,000 x 0.36 = $3,240

This shows that Don and Cheryl's total monthly debts should not exceed $3,240. (This total monthly debt expense does not include those pricey household expenses such as utilities, food, clothing, transportation, and other living expenses.)

Unlike the previous example, these potential home buyers have significantly more monthly debt. Don pays $500 monthly in child support, $100 toward a student loan, and $650 on a new car loan. Cheryl is also paying $100 monthly on a student loan. Their combined monthly payments on credit card debts total $2,000. They are already carrying $3,350 in monthly debt without a mortgage loan. This is over the $3,240 for total indebted that our ratio allows.

If we add the allowable $2,520 in allowable housing expense with the $3,350 of current monthly debts, the total is $5,870?significantly above the total of $3,240. If the lender is merely looking a the 28/36 ratio, Don and Cheryl may be out-of-luck in obtaining a mortgage with this lender.

If we add a few positive facts to these potential home buyers, we may be able to help them get their mortgage. Don's monthly child support payment obligation will end in three months and his monthly car payment obligation will be completed next month. Cheryl has been working part time as a lab technician while she has been taking classes to get her degree in medical research. Cheryl just graduated and will be starting to work full time next month, making an additional $4,000 annually, to start.

As for housing, Don and Cheryl have decided to look for a condominium close to where they both work. They are determined to keep their monthly mortgage payments below $1,200 a month, which is the amount they currently pay for rent. By looking at things
outside most the ratios, our second potential home buyers will probably be able to get the mortgage they want.
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This is how to use ratios to determine if you can qualify for a mortgage. Your qualification is more that just two numbers?it is your credit history, what is going on in your financial life, the property you want to buy, and what you are comfortable with paying for total housing expenses.

FROM MONTHLY PAYMENT TO TOTAL MORTGAGE
Homes are not sold by quotes of monthly payments. They have total prices. While knowing what your lender expects your ratio to be is important, in reality, it is how the total price of the home computes into monthly payments that means more when looking for a home.

Using the two example home buyers, we can then take the result of the 28% ratio in 28/36 calculation to determine approximately the total price of the house they should be considering.

Potential Home Buyer #1, Janet, ended up with a total monthly house expense of $980 using the 28/36 formula. She was looking for a lower monthly amount.

Potential Home Buyers #2, Don and Cheryl, ended up with a total monthly house expense of $2,520 using the 28/36 formula. They too wanted to keep that amount lower, around $1,200.

In order to determine the total price of a house that would be close to the monthly mortgage payments our buyers are looking for, go to www.interest.com. This calculates of what monthly payments would be on a mortgage loan for a specific amount.

In order to find the amount that both our potential home buyers would consider, look at the 30-year mortgages in the area of 5% to 6%. These are a few of the findings:

LOAN AMOUNT MONTHLY PAYMENTS
at 6% interest at 5% interest
$160,000 $960 $860
165,000 990 886
170,000 1,020 920
175,000 1,050 940
180,000 1,080 970
185,000 1,110 994
190,000 1,140 1,020
200,000 1,200 1,075

Again, the loan amount is the amount that you get the mortgage on. If you have a down payment of $10,000, the total cost of the house can be $10,000 more than what your loan amount is. For example, if our second potential buyers had $25,000 for down payment
they could afford a home that was selling for close to $225,000 and still keep the $1,200 monthly payment they wanted.

These numbers were all based on 30-year mortgages, you can add about $500 to each monthly payment for a 15-year mortgage. (Chapter 8 will explain the differences, in detail.)

These numbers do not include real estate taxes that differs by house, and insurance rates. Your real estate agent and your insurance agent can help you determine these numbers for the property you have selected.

Remember, these are just approximations. For exact calculations, your real estate agent and lender can help you.

COST OF LIVING INCREASES
You should also consider the cost of living. Real estate taxes, insurance costs, and utilities will almost always increase every year. Add to that the cost of food usually increases and, as we get older, so will our annual medical costs. Most of these issues vary by location and are tough for even the experts to predict. In considering what you want to spend for a house make note of the cost of living and decide if you can really live with this mortgage amount.

One way to be sure that you can survive paying a certain mortgage payment is to try it on for a few months. For example, if you are now paying $600 a month for rent and by using the ratios could afford a $1,200 monthly housing payment, try taking that extra $600 a month and putting it in a savings account. That way you are trying out the mortgage without any legal commitments. It is an eye-opening experiment that will increase your savings and may help you decide the type of home you are looking for.

YOUR LIFESTYLE
Up to this point we have been concerned with the routine ratios that lenders use, but that is not all that you should consider in determining how much you can afford to pay every month for that mortgage. Living in your own home is more than just mortgage payments. Just for the home there is upkeep, furniture, decorating, inevitable breakdowns, and utility bills. Buying your perfect home, but being unable to afford any furniture or to keep the heat at a comfortable level must also be considered. Ratios do not know how you and your family want to live. Are vacations important? Do you anticipate college expenses? Do you want to buy a new car every couple of years? These factors are part of your
lifestyle, and you should not be forced to compromise a lifestyle for a piece of property.

Another issue to consider is emergencies. If the amount of mortgage payment plus other debts leaves little or no money for savings in case of an emergency, you are cutting things too close. In our current economy, downsizing, job loss, and wage cuts have
become a reality, and everyone needs to prepare for the worst.

What a person can afford to pay in monthly mortgage payments is a personal amount. This amount cannot be just a cold calculation, but must take into count how you live and what you want to do with your life. Despite what some lenders claim, it is no longer a guarantee that people's income will increase as time goes on.

If you have a question for Diana on this or other general interest subjects, email her at info@fsboamerica.org

The entire book by Diana Brodman Summers can be bought at a very reasonable price.  It really answers a ton of questions for buyers and sellers of real estate.  Buy Diana's Book.