How Much Will Banks Loan Me? or How Much House Can I Afford?
Disclaimer: This article is heavy (like whoa heavy) on information. It’s not a quick read, but if you work your way through it, you’ll have a much better understanding of what you can actually afford and how banks really think.
It’s not rocket science figuring out what banks are likely to loan you or what you can afford. The following is a step by step guide to help you narrow it down before you apply with a lender. Once you’ve done the math, determine how much you want to actually spend on a house. You’ll likely find that you won’t want to spend nearly anywhere close to the maximum amount you’d be able to borrow, or that you need to curb some of your expectations.
Step 1: Look up your credit score to determine what loans you’re eligible for.
Prior to the 2008 housing market crash, it was the wild west when it came to credit scores and mortgages. Just about everyone was approved (which is one of many reasons the crash happened). Thankfully, things have changed and banks are lending money more responsibly.
When deciding whether or not to lend money, the first thing banks look at is the borrower’s credit score. Going from 300-850, credit scores are broken down into the following ranges
Very Bad= 499 or lower
Excellent= 720 and above
Unfortunately, to get your credit score will take a little bit of work on your part. Some banks give their account holders monthly updates on their credit score for free. If yours doesn’t, you may have to pay a few bucks. You can get it from either of the three credit bureaus (Experian, TransUnion, or Equifax), but the one banks are more likely to use is your Fico score.
Don’t make the mistake of going through www.annualcreditreport.com; that’s not what you want. A credit report, though useful, does not include your score but rather a detailed history of such things as on-time payments, loans taken out, and available credit — all of which are analyzed to create your credit score by a third party provider. A credit report reveals a lot about you (and you can be sure lenders are looking at it), but what you want is your credit score.
Credit scores determine what types of loans you’re eligible for, thus the minimum score needed for each loan type is different (for a detailed report of all the different types of loan types, click here).
The minimum credit scores needed for the most popular loans are:
A low credit score equates to higher interest rates and higher monthly payments— meaning the true cost of your house will be much higher than the purchase price because of higher interest. It will take you just as long to pay for it, but your monthly payments will be higher.
Step 2: Determine Your Gross and Net Income.
Gross income is the amount you make before taxes and health insurance are taken out— whereas net income is basically how much money you have to spend after Uncle Sam has his say.
To determine net, if you get paid the same amount twice a month, take the amount deposited into your account and multiply it by 24 to determine your yearly net income. If you’re salaried, hopefully you already know how much you’re paid per year.
*If you’re hourly and need to determine gross, take the amount of hours you work per week and multiply it by 52. Then take that answer and multiply it by how much you make per hour.
It’s helpful to know both, but gross income comes into play more than net for lenders when determining a borrower’s credit worthiness.
Step 3: Determine Your DTI
Your debt-to-income (DTI) ratio will influence whether lenders are comfortable lending to you. In a nutshell, your DTI is an analysis of what you bring in each month compared to what you send out to pay for your debts.
To calculate your DTI:
Add up all of your monthly debts. These may include:
Student loan payment
Credit card payment
They do not include:
Step 1: Divide the total from step 1 by your gross income.
Step 2: The answer you get is your DTI (math recap: multiply it by a 100 to turn it into a percentage). A low DTI suggests that you are more likely to pay back upon your debts and are therefore less of a risk to lenders.
There is, however, a magic DTI number banks won’t let borrowers go over when purchasing a home. That number is 43%. Put that number in your backpocket for now. We’ll come back to it later.
Step 4: Determine what is 28% of your monthly income.
When lending to home buyers, banks prefer that mortgages only take up 28% of a borrower’s monthly income. Some are willing to go as high as 35%, but 28% seems to be the agreed upon sweet spot. If you gross $4,000 a month, the amount of your income that could go to a house payment would be $1,120, but this amount should include interest, principal, property insurance, property taxes, and mortgage insurance (we’ll go into calculating those in step 5).
Since 2010, banks are only allowed to go up to 35% of your gross. However, don’t think that just because you can go up to 35% that you should. While you may technically be able to afford it, you won’t be able to do much else. If you enjoy eating out and making random Target trips once in a while, 35% won’t leave you any petty cash to do those kinds of things.
Getting yourself into a high mortgage payment is what old timers used to call being ‘house poor’.
Step 5: Calculate a home’s PITI to estimate the total monthly payment.
PITI stands for principal, interest, taxes and insurance, and represents the true cost of a monthly mortgage payment. If you get a fixed-rate loan, your principal and interest are going to stay the same. However, what is likely to change year to year are taxes and insurance. Depending on the economic climate, they could go up or down.
You need to understand what your total monthly payments are going to be because the grand total will affect how much your monthly mortgage payment will take up of your monthly income. Remember, banks prefer mortgage payments to stay at or below 28% of your monthly income. Being able to afford principal and interest doesn’t necessarily mean you can afford a particular house. When you include PITI, a borrower’s DTI (debt-to-income) may become too high. This is why calculating PITI is important. It’s the difference between being able to afford and not being able to afford a house.
Run the numbers:
So how do you calculate PITI? It’s a little complicated, but is quite doable.
Determine the total loan amount. You’re still in the planning phases, so you’re going to have to estimate. If you plan on making a downpayment, don’t count that amount. Subtract that amount from the total expected purchase price to get the amount your bank will loan you.
Do you plan on doing a 15 year mortgage or 30 year mortgage? Most people go with 30 because they plan on selling one day in the future and want a lower monthly payment in the meantime.
Estimate an interest rate. Unfortunately there’s no way to help you narrow down a rate because it changes every day and each bank has its own way of calculating it.
A safe way to estimate it is to add a point to the national average. Better to go over and be pleasantly surprised than to get sticker shock once you’re further along in the process! As of this writing, for a 30-year fixed mortgage the starting rate is 4.75%, so a safe estimate would be 5.75%.
Go to a mortgage calculator and key in the total loan amount, total years of payments (15 or 30), and interest rate. This will get you the total you’ll pay for principal and interest, but from here on out you still need to know taxes and insurance.
Home Insurance will vary depending on where you are and what type of home you buy. Generally speaking, most people pay somewhere between $300 and $1,000 a year. To estimate, take the total value of the home and divide it by 1,000. Multiply that number by 3.5. Finally divide by 12 to get the monthly payment.
Example: Total value of home is $250,000. Therefore:
250,000 / 1,000= 250
250 * 3.5= 875
875/ 12 = $72.92 per month.
Note: This will vary year by year because the value of your home will change depending on the housing market.
1. Next up is mortgage insurance. If you don’t put 20% down, you’ll have to pay mortgage insurance. However, what you pay will vary depending on the loan you get. That said, for a standard FHA loan, take the total loan amount and multiply it by .0055. Next divide that number by 12 to get the monthly payment.
Example: Total loan amount is $241,250 (because of 3.5% down-payment). Therefore:
241,250 * .0055= $1,327
1327 / 12= $110.58 per month.
2. Find the annual property tax bill. Most sites like Zillow or Realtor will have the home’s taxes printed somewhere on the listing. Whatever the yearly tax amount is, divide that number by 12 to get the monthly amount.
Example: In Zillow, under Tax History, a random $250,000 house with standard acreage pays $1,525 a year in property taxes. Therefore:
$1,525 / 12= $127.08
3. HOA fees? For now, let’s assume your dream home doesn’t come with any HOA fees. Just don’t forget to ask once you get closer to buying!
4. Lastly, add everything up to get your total monthly payment.
$250,000 house with 3.5% down= $241,250.
With a 30 year fixed mortgage and a rate of 5.75%, the monthly principal and interest would be $1,408. So—
$1408 (estimated principal and interest)
+ $72.92 (estimated home insurance)
+ $110.58 (estimated mortgage insurance)
+ $127.08 (estimated property taxes)
$1,718.58 total monthly payment.
Take this amount back to step 3 and 4 to calculate both DTI and percentage of income.
Step 6: Putting it all together.
Information overload, right? How do you even begin to put it all together?
First let’s assume the borrower has a normal credit score (the current national average is 687). Other than a Jumbo loan, she should be fine getting a loan. She holds a steady job and brings in about $50,000 a year, which puts her monthly gross at $4,166.
The next major milestone is that her mortgage payment (which includes PITI), should be no more than 28% of her gross monthly income. Again, banks can legally go up to 35%, but every financial adviser out there recommends borrowers stay at 28%.
With her other monthly debts, her new mortgage can not put her DTI over 43%. If she wants to buy that $250,000 house mentioned in the previous step, her monthly mortgage would be $1718.58.
The problem is she owes $350 a month for student loans and car payments.
$350 + $1718.58= $2068.58
$2068.58/ $4,166= 49.6% DTI.
Unfortunately, in this example the borrower can not afford the house she wants because her debt-to-income ratio would be 6.6% higher than what banks are comfortable with. If she did not have $350 worth of monthly payments, her DTI would only be 41%, but here again the mortgage would still be 6 points over 35% (the highest recommended percentage a mortgage should take up of monthly income).
Without other debt, the most banks would comfortably allow her to spend each month is $1458.10, but if she was smart she wouldn’t let herself buy a house that expensive— because who enjoys not going on vacation or eating out? What kind of life is that?
Plugging in all of her information into a mortgage calculator, the most this borrower should spend on a house would be around $150,000. Yes, it’s a starter home, but at least she’s building up equity every month instead of completely handing her money over to someone else. 5% interest is a lot better than 100% interest!
Now that you know, take control.
There’s something to be said for knowing how the world works, isn’t there? As you now know, it takes just a few minutes to do the math. Once you’ve obtained a comfortable price point, you can begin the fun part: house hunting.
Happy hunting, hipster.