For many individuals and families the purchase of a home is the largest purchase they will make in their lifetime, and determining how much to spend is therefore very important. How much of a house you can afford will depend on the amount of your income as well as the stability of your income. The lender or originator of the mortgage will be happy to tell you how much home you can afford according to their standards, but these standards are designed to manage their risk, not yours. Although oftentimes your interests happen to be aligned, it is important to do your own careful analysis of your financial situation before purchasing a home. In this article we will discuss ways to determine how much home you can purchase using an analysis of your income, cash flow, assets and liabilities, and financial objectives and goals.
Bank/lender underwriting standards
The bank, lender or originator of the mortgage has certain guidelines which they use to determine whether or not you meet their criteria. The two most important metrics which they use are the “front end ratio”, which is designed to measure the house payment in relation to your gross income, and the “back-end ratio”, which is designed to measure your total long term liabilities in relation to your gross income. Other factors are used as well, but these two metrics are the ones which are most easily quantifiable. A standard which is frequently used for a good credit score is a 28% front-end ratio and a 38% back-end ratio. In other words, if your gross monthly income is $10,000 your principal, interest, taxes and insurance can not exceed $2,800 per month. Similarly, your principal, interest, taxes, insurance, installment loan payments, credit card payments, and student loan payments combined can not exceed $3,800 per month. Note that loans which are scheduled to be paid off within the next 12 months are considered a current, not long term liability and are thus not included when calculating the back-end ratio.