When looking at buying a house, there are a lot of things to consider. Do you NEED a two-car garage or do you just WANT a two-car garage? Do you have a school district preference or prefer a certain city so you can be closer to work? Do you want a rambler or a two-story and do you need a fenced-in yard for your furry family member? Do you prefer to avoid outside maintenance, making a townhome a better option? Is it important the house is updated or are you pretty handy at DIY?
Some of these decisions are a basic “wants” vs. “needs” analysis. Obviously, if you had a household of four people, a one-bedroom home won’t cut it – that would be a “need,” whereas having a pool in the back is more of a “want.” Lot’s of things to take into account. The most important though, should be what price home, or payment, that you can really afford. Buying a house isn’t just a house payment for the next 30 years – it’s a commitment along with other financial responsibilities.
Many of you may be renting right now and, quite possibly, could be paying more in rent than what you can afford for a house payment. One of the mortgage lender’s goal is to help you get financing, but the main goal should be to make sure that whatever financing you obtain, you are comfortable with the payment. Let’s face it, you’ll have this payment for the next 30 years and eating ramen noodles every night doesn’t sound like fun.
So how do we determine what payment/price you can afford? Lenders use something called ratios to determine your qualifications. Ratios take a certain percentage of your GROSS monthly income, taking into account other monthly debts you have, to come up with a maximum house payment. Sometimes, that top-end payment is NOT what you want to pay because it puts you out of your comfort-zone. And if that’s the case, please let your lender know that! There is no reason you should ever pay more per month than what you financially can afford. You know your spending habits much better than your lender. That said, if you think you can spend more than what the lender determines you can afford, we can’t increase it just to make you happy. To make that work, your income has to be higher, debts lower or you may need a co-signor or co-borrower to bring that payment to what you feel you can afford.
Different loan programs have different guidelines for ratios. One constant is that your monthly income is looked at in gross terms versus net (after taxes/deductions). The exception to this is if you’re self-employed. In this situation, we look at the NET profit or loss on your federal taxes (assuming a schedule C filing) since this is what you got taxed on. Also, different types of income might be looked at as an average over two years. You’d want to check with your lender about how they will look at your specific situation. For now, let’s keep this simple and use an FHA example assuming the person is salaried at $5000/month and has $650/month in debts.
In the example below, notice that there are TWO percentages being used. The first, we call the housing ratio. This determines the maximum house payment you can make based on your monthly income. The second is called the debt ratio. This is based off your monthly income too, but now factors in any monthly debts you have (credit cards payments, car loans, other house payments, installment loans, lines of credit, ongoing payments to the government for taxes, alimony, child support, overdraft protection balances, etc.) We will take the lesser of the two calculations to determine the maximum payment you can afford. FHA guidelines allow 31% for the housing ratio and 43% for the debt ratio. Some lenders may be willing to exceed these ratios, please check with your lender.
In this example, the buyer can afford a $1500/month house payment. The payment includes principal and interest on the loan, a monthly amount for property taxes and monthly amount for hazard/homeowner’s insurance and monthly mortgage insurance, if applicable. If you were looking at a townhome, or something with monthly association dues, the lender would also factor this into the maximum payment you can afford.
Let’s say $1500/month puts you at a purchase price on a single family home (no association dues) at $220,000. You’ve gotten yourself pre-approved and are out looking at homes. Did you know that you could look at multiple homes, ALL listed at $220,000, and possibly not qualify for ANY of them? I know, I know … but your lender said you could look homes at that price. So what gives? Ultimately, you are getting pre-approved for a house payment, NOT a price. The price of the property is a guide, so to speak. In this example, if the lender used $229/month for the property taxes and ALL the homes you looked at had taxes higher than $229, then your payment would end up being higher than $1500, hence you wouldn’t qualify. Not only will taxes affect the price you can afford, but so can the interest rates, association dues and hazard/homeowner’s insurance. These are all moving parts to the home purchase puzzle!
As lenders, we do our best to give you an approximate price point, but knowing the above will hopefully help you understand that some houses you look at, though you were told the price would work, just won’t. Alternately, the house you look at could be $190,000 and the taxes could be crazy high, making the payment higher than $1500, meaning you can’t afford even THAT lesser priced home. It’s nuts, I know.
Remember I mentioned this was a single family home? Pretend you change your mind and start down the townhome or condo path. If that should happen, then your $1500/month payment MUST also take into account association dues, which can vary dramatically. This will lower your purchase price power approximately $20,000, maybe more depending on the dues. Best advice here – talk to your loan officer if you decide to change property types so you can get a more accurate price range to be looking in.
So the question – “I can afford that, right?” has the wishy-washy answer of “maybe.” First, remember your income and your monthly debts will determine WHAT payment you can afford monthly. And second, the payment you can afford will get varying results on whether you can afford a specific house depending on interest rate, property taxes and homeowner’s insurance amounts. Your lender will get you pretty close to the price range you can look in so you have a starting point, but at least now you have a better understanding as to why you might not be able to buy the house you thought you could afford.
My goal is to provide education and a clear understanding of the process and your goals. It would be my pleasure to help you with your homeownership journey.