Are you considering investing in the American Dream? Great idea! You may even have your eye on a certain home that is currently on the market for sale. Let me reassure you that buying a home is a great move for many reasons. But before you get too far you need to make sure you qualify for a mortgage, unless you are going to be paying cash! But how much can you qualify for? Before making an offer on a home you will want to know how much purchasing power you bring to the table.
In this write-up I will show you how lenders will determine your potential purchasing power by using a set of debt-to-income (DTI) ratios that will tell them your pre-approved max loan amount. The DTI lender guidelines were put into place by financial institutions for most common types of mortgages and are geared toward protecting the lender’s overall risk. (You will also need a credit score of at least a 580 to qualify for most mortgage programs. Max DTI’s are for those with better credit & assets.)
The benefits of home ownership are abundant, from stability and wealth growth to responsibility and pride of ownership. Knowing how much you can afford will help you decide if buying in today’s market makes financial sense for you today or if you should wait.
There are two (2) types of DTI ratios that lenders will use to determine your max loan amount. Both DTI ratios use your monthly gross income amount. These two (2) types of DTI’s are called back-end and front-end DTI ratios.
The back-end DTI ratio tells the lender what your max amount of debt payments can be each month. (Typical monthly debt payments might include: car payments, credit card payments, student debt payments, and your new home payment combined.) The front-end DTI ratio tells the lender how much your max home loan payment can be each month. (Your current monthly debt payments will lower your possible monthly payment for a home, which in turn lowers your max loan amount. Paying off debt will increase your max loan amount.)
Now that we know what DTI ratios are, and how important they are in determining your max loan amount, let’s go over the numbers the lender will use to determine your purchasing power.
The first thing that needs to be done is to take your gross yearly income and divide that number by 12. That is your gross monthly income amount. Based on FHA type financing guidelines your back-end DTI can be no more than 43%-56% of your gross monthly income, depending on certain contributing factors. If you use Conventional type financing, you may be able to use up to 45%-50% of your gross monthly income. (Should you use FHA or Conventional financing? The answer will depend on many factors that we can discuss at another time if you’d like.)
After figuring your back-end DTI ratio the lender will make sure your monthly mortgage payment is not exceeding the front-end DTI ratio guidelines. Some lenders want to see your front-end DTI ratio up to 31%, but many will allow you to go up as much as 43%+ for FHA and Conventional type financing.
OK, so let’s say the home you have your eye on is listed for $275,000 and you make $75,000 a year. (If you are buying with a spouse or significant other, you can add their gross annual wages to yours. You will also need to add their monthly debt payments.) When dividing $75K by 12 that gives you a gross monthly income amount of $6,250.00.
Using that gross monthly income amount, and say you use FHA type financing (3.5% minimum down payment required), you can have a back-end DTI amount between $2,687.50 – $3,500 (43%-56% max debt payments per month), and a front-end DTI amount between $1,937.50 -$2,687.50(31%-43% max home payment per month).
If you have current monthly debt payment’s you would now subtract those from the back-end DTI amount above… or you can wait to see what your estimated monthly payment will be and add the payments to that. For the purpose of this example let’s assume there are no other monthly debt payment’s to worry about.
Now that we know what your max front-end and back-end DTI’s can be, we can go to www.BankRate.com and use their Mortgage Calculator. We then plug in a purchase price of $275,000, plug in the down payment amount of3.5% or $9,625 for FHA type financing, use the default interest rate (4.88%today) and then hit calculate. That gave us an estimated monthly payment, for your principal and interest, of $1,405.19. Now you still need to add your monthly homeowners insurance amount, your monthly real estate tax amount, and because we are using FHA you will have to add in your monthly mortgage insurance amount to get your final monthly home payment.
For the sake of argument let’s say the taxes are $2500 a year, your insurance is $1,500 a year and your PMI is $188 a month. That adds an additional $520 to your monthly principal and interest payment, for a grand total of $1,925.19 per month.
Great news! You WOULD qualify for a purchase price of $275,000 based on your DTI ratios if you made $75,000 a year.
Ok, so now you know what debt-to-income ratios are, and how they affect how big of a mortgage you can qualify for.
Are you ready to get pre-approved? It will cost you absolutely nothing to confirm your purchasing power. The lender will also need to verify your income and confirm your credit score is over 580. I’d say it is pretty much smooth sailing after that, but I must be honest. Buying a home may be one of the most stressful life events you will encounter. If you have a good Realtor® they will help reduce the stress level by looking out for your best interests.
If you are considering buying a home let’s talk about how much purchasing power you have. Call Alex to discuss further at 941-822-1519.