How to Know What You Can Afford in a Home

The transition to spring brings out an extraordinary amount of newness and change - Budding tree leaves, blossoming flowers, swollen rivers and even new baby animals. It also brings out new “For Sale” signs on homes all across the nation.

Over the past ten years, we have learned that housing sales contribute enormously to our national economy, but how do those house sales impact our own pocket books and how do we know what we really can afford?

To answer this question, you have to look at your debt-to-income (DTI) ratio. Your DTI is the amount of debt payments you make each month divided by your total gross monthly income (before taxes). For instance, if your gross monthly income is $5,000 and your debt payments are $500, your DTI equals 10%.

There are some general rules about DTI. First, look at your percentages without including housing costs.

If your debt-to-income ratio is:

• 15% or less – you are in good shape. If you needed to take on additional debt, you would probably be able to do so.
• 15% to 20% - You may need to look at how you can start reducing your debt in order to avoid being over extended.
• More than 20% - indicates either you are or may begin to have difficulty making your payments.

Of course, our examples are based on someone who is responsible for normal monthly expenses such as rent, utilities, groceries, etc. If you have no other debt or expenses (maybe you live with someone else who pays most of the bills), you may be able to take on more debt. But, you have to be cautious.

Housing costs have their own debt-to-income ratio. For housing, whether you are renting or buying, the amount you pay should make up 28% or less of your gross monthly income. When you hear people talk about front end ratios they are talking about this percentage. It only includes the housing payment.

When we include all of your debt payments and your mortgage or rent, the backend percentage should be no higher than 36%. This means that, hypothetically, 28% would be for the house and 8% for all other debts. However, some programs allow a back end ratio as high as 41 – 43%.

The question then becomes: should you spend the maximum you can when selecting a home or should you leave a contingency buffer in your monthly budget? Buying less house than you can afford can allow you to have funds available for repairs, improvements, or additions. This also leaves room for any downward changes in your income or unexpected expenses.

Here is an example from Seattle, WA. Both houses have 2 bedrooms and 1 bath. Both are 710 square feet. They are also within five blocks of each other.

• House #1 – Move in ready. Cost is $299,500
• House #2 – Move in ready. Cost is $279,500

The difference in price is $20,000. The difference in the mortgage payment is $96 per month. The difference in the cost over the life of the loan is $34,374. That is money you could use toward retirement, paying down other debts, or making home improvements.

Of course, there are other considerations when buying a home. This includes your credit score, which should be 740 (FICO model) or higher, and the down payment you can place on the home. It is possible to buy a home with a credit score of 640 and sometimes lower. However, it has to be the right kind of loan and the right lender. Be sure to shop around.

The typical down payment you will need is 3.5% of the purchase price. If the home costs $300,000, you would need a $10,500 down payment. If necessary, look for programs in your area that offer down payment assistance. These programs or loan options can cover the full amount necessary for the down payment.

There are also lending programs that do not require a down payment. Be sure to ask your lender for more information.

As you can see, it is critical to be sure the mortgage payment will fit in your budget and hopefully without causing a strain. Changes in job status, medical emergencies, and economic factors can all create a situation where a mortgage becomes difficult to pay. Focus on finding a home that fits your needs and leaves room for financial changes. 

Published Apr 3, 2015.