Lenders apply a rule of thumb for determining how much home you can afford. The rule of thumb is based on the percentage of your monthly pre-tax income (gross income) you can afford to spend on housing costs, as well as housing costs plus other recurring debt payments.
Here are key ratios used to determine how much home you can afford, and a handy calculator for your specific situation.
Front-end ratio: 28-31%
The first rule of thumb for mortgage affordability is called the "front-end ratio," which looks only at your housing costs. This ratio includes principal, interest, taxes, and insurance (PITI) payments due as a percentage of your gross income on a monthly basis.
We'll use an example to demonstrate how the front-end ratio works. Let's assume you intend to purchase a home and expect to pay the following amounts in principal, interest, taxes and insurance each month.
Principal & interest: $900
Your total PITI payments are $1,300. We'll assume that you earn $5,000 per month. Therefore, your "front-end ratio" is $1,300 divided by $5,000, or 26.5%. This puts you in a good range for how much of your income will be consumed by housing costs. Conventional loans typically require a front-end ratio of 28% or less, while the FHA will accept front-end ratios of 31%.
Though important, the front-end ratio is not necessarily the most important ratio. A second rule of thumb, the so-called "back-end ratio" is often more important to lenders, because it includes other recurring monthly payments to determine how much home you can afford.
Back-end ratio: 36-43%
Where the front-end ratio looks only at your direct housing expenses, the back-end ratio includes your housing expenses in addition to other monthly recurring payments (credit cards, car loans, child support payments, and student loans) that extend beyond the next 10 months. Recurring non-debt payments aren't considered here -- lenders don't care about your cable or phone bill.
Again, we'll use another example to calculate a back-end ratio, building on our earlier example.
PITI on home: $1,300
Car payment: $200
Student loans: $150
Credit card: $50
Your total monthly debt obligations add up to $1,700. If you earn $5,000 per month in gross (pre-tax) income, then you have a "back-end ratio" of $1,700 divided by $5,000, or 35%. This is good to see, since it is just inside the 36% threshold for conventional mortgages, and well within the 43% requirement for FHA mortgages.
How much do ratios matter?
As with anything in finance, there is some leeway, and there are a number of different ways that these ratios can be relaxed for borrowers. For example, just for buying an energy efficient home, the FHA relaxes front- and back-end ratios to 33% and 45% vs. the standard 31% and 43% limits. Lenders can also relax the requirements with a sizable down payment, for example.
Ultimately, lenders always have discretion in making a loan, and can consider other factors in their underwriting process. The truth is that a lender can theoretically lend you any amount of money, but these ratios stand as a good rule of thumb for determining how much you can realistically afford to borrow in the real world. I would suggest using the standard 28% and 36% for front-end and back-end ratios in the calculator below. If the results aren't exactly what you'd like to see, continue scrolling for a few ways to increase how much you can afford to spend on a home.
Ways to increase how much home you can afford
Home affordability is primarily a function of three factors: how much you earn, your minimum monthly payments on other obligations, and your credit score. There is only so much you can do about your income. Storming into your boss's office to demand a raise so that you can afford a bigger home probably isn't a realistic solution to failing a ratio test. That leaves reducing non-mortgage debts and improving your credit score as the best options.
In general, paying off debts with the highest monthly payments as a percentage of the balance will result in the biggest increase in the amount of home you can afford. Credit cards typically require minimum payments of about 3% of your current balance, or $30 per $1,000 in balances. Paying off a small amount of credit card debt can have a big impact in how much home you can afford.
Other consumer debts like car loans are also good debts to target for payoff prior to applying for a mortgage. Remember that lenders generally include recurring debt payments into your back-end ratio when they will be recurring for the next 10 months or more. Waiting for an existing debt to fall under the 10 month threshold, or paying it down to that level, will increase the amount of home you can afford. Of course, paying it off in full would be the ideal outcome.
Working on your credit score
Some borrowers may be able to modestly improve their credit score prior to applying for a mortgage, resulting in a lower interest rate, and the ability to buy a more expensive home. It's generally accepted that a 740 FICO score is good enough to qualify for the best terms on a mortgage from any bank or lender. Logically, having a good credit score results in a lower interest rate, resulting in more borrowing power to buy a home.
Paying down your revolving debts (credit cards or lines of credit) to less than 30% of each credit limit can have a tremendous impact on your score. Credit scoring algorithms punish borrowers who use more than 30% of their credit limits. Conveniently, paying down revolving debt is a double whammy, potentially improving your credit score and your back-end ratio at the same time.
The next best thing you can do is avoid common pitfalls before going to the bank for a mortgage. Avoid applying for new credit cards, car loans, or other loans to avoid racking up credit inquiries on your report. Recent credit inquiries can result in a lower credit score, and scare some lenders who will think that you're desperate to borrow more money to stay current on other obligations.
Finally, head on over to AnnualCreditReport.com, a website where you can get your credit reports from the three major credit bureaus for free once a year. Verify that the information in each report is accurate. You can dispute any inaccuracies immediately and easily online. AnnualCreditReport.com was created by the three major bureaus to provide free access to your reports under the requirements of a government law. But whatever you do, don't pay for access to your credit report. There isn't any reason to.
Unfortunately, credit reports frequently contain errors that can impact your ability to borrow, and the rate you pay. A study by the Federal Trade Commission found that 5% of people had errors on their report that would impact their rates on loans and insurance products, and one out of every 250 people had errors on their report that would impact their score by more than 100 points! To put that in perspective, a borrower with a 620 score could end up with mortgage payments that are 20-25% higher than someone with a 720 score.
Above all else, remember that what you can afford to spend isn't necessarily what you should spend. It wasn't all that long ago that the greatest financial crisis in a generation was spawned by America's collective belief that everyone should borrow as much as possible to buy a home, or two homes, or ten homes. Living in an expensive home is certainly nice, but not at the cost of living paycheck to paycheck.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.