Formula for How Much House I Can Afford

What is the formula to figure out how much house a buyer can afford? 2 times the yearly income or 3 times the yearly income?

1 Answer

While the price of a house someone can afford may coincide with their income times a multiple of two or three, the actual determination of " How much can I afford?" is somewhat more complex. Income is definitely a factor. There are several others.

Here's the "Reader's Digest" version of how it works:

Lenders typically establish guidelines for what loan applications they will and will not accept. Among other things, those guidelines establish a minimum down-payment for which a borrower will qualify. Right now, just about everyone out there has eliminated "zero-down" financing. So, if your credit score dictates that you need a down payment of at least 10%, and you only have 5%, your yearly income will not factor into the equation until you save up the required 10% or improve your credit to the point that you will qualify for a down payment that you can afford.

The next factor that has to be determined is the interest rate for which the borrower qualifies. As a general rule, the better someone's credit score, the lower the interest rate for which they will qualify. This is very important, as we will see below.

Once a lender determines that the borrower has a down-payment that meets its requirement, and once the lender determines the interest rate for which the borrower qualifies, the next factor that the lender looks at is the "debt-to-income" ratio. This number is a measure of someone's total monthly debt obligations - including the proposed housing payment - divided by their gross monthly income. The housing payment includes not only the monthly mortgage payment, but also real estate taxes and property insurance. If the property is a condominium, the figure will include association fees. If the property is in a flood plain, flood insurance has to be taken into account. If the down-payment is less than 20%, the lender may require mortgage insurance, which would also be included in the total monthly housing payment. As you know, for a given loan amount, the higher the interest rate, the higher the payment. The higher the payment, the higher the debt to income ratio.

Some lenders consider only the total monthly debt obligation. That is to say, they figure out the housing payment, add up your monthly revolving debt (minimum credit card payment s, car loan payments, student loan payments, child support, etc), put the two together and if that number divided by your gross monthly income is less than the required percentage, you pass that part of the test. Most subprime lenders use a 50% debt to income ratio as their maximum. So, if the lender requires that the debt-to-income ratio not exceed 50% and your housing payment, plus all your other monthly obligations add up to.

Other loan programs, such as those for loans insured by the Federal Housing Administration, look at debt ratios differently. Not only do they establish a maximum total debt ratio, they also establish a maximum housing debt ratio. For FHA loans, absent compensating factors in other aspects of the loan, the housing payment-to-income ratio may not exceed 29% and the total debt-to-income ratio may not exceed 41%.

Conventional/conforming loans are a different animal altogether. Because those loans applications are underwritten by a computer program (referred to as an automatic underwriting system or automatic underwriting engine) that looks at the totality of the borrower's application, there is some "give" in terms of maximum debt-to-income ratio. For instance, if a borrower is making a large down-payment and will have significant savings left over after the purchase, the program's algorithm will be more tolerant of high debt ratios than it would be for someone making a small down-payment who will have little money left after the purchase.

To get the heart of your question, how much you can afford depends on alot of things. Your credit score determines the down payment you have to put down and the interest rate for which you are eligible. The interest rate, in turn, determines the mortgage payment. On top of that, the real estate taxes for the house you want and insurance rates common in your area get factored in to determine the total monthly housing payment. Those are all variables which need to be taken into account. The other variable is your monthly debt.

Given all of that, we see that two people who have identical savings, credit scores and yearly income may not be able to buy the same house because one has $1,000 in monthly credit card debt and the other doesn't. Similarly, all else being equal, a person might "be able to afford" a $150,000 house on one side of town, but not a $150,000 house on the other side of town because of higher taxes and insurance.

If you asked this question because you are in the market to buy a house, my best advice to you would be to seek out the services of a knowledgeable and experienced mortgage professional. That person will be able to analyze your finances and give you a very accurate picture of what you can afford. And, if you have issues which affect your buying power, your mortgage professional can give you advice on how to improve your credit and pay down debt so that you can qualify for the kind of house you want.