When trying to decide your home buying budget, the first step is to determine your personal comfort level on what you can afford. How much can you put down? What can you afford to pay out monthly? Before you meet with a mortgage lender, a thorough evaluation of your personal financial situation is an absolute must.
The reason it’s important to do this on your own is that you may have expenses or financial goals to meet that the lender won’t take into consideration when approving you for a loan. Never let someone else dictate what your mortgage payment comfort zone is going to be. You can use your current comfort level with your rent payment, and look at your monthly income and expenses to estimate your own ideal mortgage payment.
Step one is always to sit down, discuss that number with your spouse and come to a very firm conclusion that despite what your loan officer or real estate agent might say, you will stay firmly committed to not exceeding.
Making YOUR Own Budget
As a homebuyer you can, but shouldn’t, rely on a bank to tell you how much home you can afford. In many cases, your bank will approve you for a more expensive home than you want to purchase. This is because banks will approve you to your maximum home price using a 45% debt-to-income ratio.
Before you begin your home purchase process you will need to get a rock solid mortgage pre-approval. A huge part of the home purchase pre-approval process is getting your baseline numbers together on what you can actually afford. It all starts with your debt-to-income ratios.
Before we dive into how that number is calculated, let me offer a word of caution. When first-time homebuyers, myself included, start the home buying process, our eyes often get big. We separate reality. What we had planned to spend grows. It could be pressure from an agent or a spouse. It could be your loan officer is overly optimistic. Avoid this trap at all costs.
Just because you are told the maximum you can afford, it does not mean you should attempt to buy at that maximum. Buy within your means. Just do it.
Set YOUR comfortable payment level before you start searching and stick to it. Make sure you include all the costs of home ownership when you come to your number. That includes, but is not limited to, your mortgage payment plus your real estate taxes, homeowners insurance and any potential homeowners association dues if applicable.
Your Debt-to-Income Ratios
The first component of the debt-to-income ratio is the “front-end ratio.” Front-end ratio compares the expected monthly housing payment to a buyer’s monthly income, where “housing payment” includes all of the following obligations:
- Monthly principal + interest payments
- Monthly real estate taxes due
- Monthly homeowners insurance due
- Monthly dues due to an association
There is no maximum limit for a front-end ratio, but lenders prefer to see front-end DTI of 28% or less. In other words, banks prefer that 28% or less of your total monthly income allocate to your housing payments. You can still be approved with a front-end ratio greater than 28%, but it’s a little less usual.
The second component of your debt-to-income ratio is your back-end ratio or your total debt to income. Back-end ratio compares the monthly housing payments against a buyer’s monthly income, and all other monthly payments, too. Back-end ratio accounts for all of the following monthly obligations a homebuyer may have:
- Monthly housing payment(s)
- Monthly minimum credit card payments
- Monthly child support or alimony
- Monthly car payments for a car loan or lease
- Monthly payments to an installment loan such as a timeshare
- Monthly paycheck deductions for 401k or other employment specific loans
In general, banks want to see a back-end ratio of 36% or less; however, having a DTI over 36% will not disqualify your loan application automatically. Many lenders allow up to 45% debt-to-income.
Once you have your budget and your debt-to-income ratios fully calculated you will be in a much better place than most home-owners. Set yourself up for success and do the legwork needed to be a successful first-time homebuyer.
Amazon.com Best-selling author, Shashank Shekhar (NMLS 8176) is a mortgage lender with Arcus Lending, offering loans for home purchase and refinance. Shashank has been featured as a mortgage expert on Yahoo! News, ABC, CBS, NBC and FOX. He has been named "Top 40 under 40" most influential mortgage professionals in the country.
