It can be overwhelming trying to calculate how much house you can afford, especially if it’s for the first time. There are so many factors to take into account that it can be tough to know where to begin.
There’s a good general rule of thumb, though, for figuring out how much house you can afford, and it’s the same one that lenders use when they try to figure out whether to give you a loan or not. That rule of thumb is called your debt to income ratio.
Your debt-to-income ratio is simply the difference between how much you make each month and how much you spend each month.
Naturally there is some variation from month to month, but some expenses are set in stone and others are easily calculated. Since it’s impossible for you to afford to buy more than you make, this gives you a pretty good starting point for calculating how much house you can afford.
Even though debt to income ratio (usually abbreviated DTI) has the word “debt” in it, the definition of “debt” is being loosely applied. When we talk about a consumer’s debt-to-income ratio, we aren’t just looking at loans the consumer is paying back and so on—we’re looking at all monthly expenses.
These are known as the front-end ratio and the back-end ratio. Athough it’s counterintuitive, you should start by looking at the back-end ratio. The back-end ratio includes the percentage of your income which goes toward paying all your existing expenses.
These expenses include all monthly recurring payments on credit cards, vehicles and other loans. They also include things like alimony payments, court payments, and student loans. Taxes are considered back-end expenses. Insurance payments count too.
And while a bank may not care, you should factor groceries and commuting costs into your back-end ratio. Whatever you pay in order to survive each month should be factored in.
Your front-end ratio includes the percentage of your income which will go toward your housing costs. This includes your mortgage principal and interest, your homeowner’s insurance (if applicable), property taxes, and any additional fees which you owe either your lender or a homeowner’s association.
Do not neglect your electric bill, water bill, telephone bill, and other utilities either. These payments don’t fit squarely under either category, but like your groceries and gasoline, they’re still monthly expenses, and you still need to subtract them from your income each month to determine what you can afford.
Usually when lenders calculate your DTI, they express the back- and front-end ratios in the form x/y. Note that lenders won’t calculate what you can afford the same way you will, since again they tend to ignore a lot of real life expenses (like food).
You’ll want to calculate your DTI both ways. A typical DTI ratio which will be acceptable to a lender for a conventional loan is 28/36 (make sure you do some further research to learn how to calculate this number).
If a lender doesn’t feel you have an acceptable DTI, you probably don’t (after all, your lender is probably being generous with the estimate by ignoring so many of your monthly real life expenses). If a lender does feel you have an acceptable DTI you still need to do the math yourself and make sure that with all your living expenses thrown in you really can afford the house.
What do you do if you can’t afford to buy a particular house?
You can either search for a more affordable house (by looking in a rural region for example), or you can wait before investing in a house.
Waiting isn’t usually the end of the world—consider how many people years ago took out mortgages they couldn’t truly afford, and how many of those people now have been foreclosed on.
Part of being a responsible person is making sure you don’t take on more than you can handle, and for many people a house is just that. There’s nothing wrong with waiting until you have a more stable income or a higher income before you choose to purchase a house.
You’ll be paying off on your house for many years (assuming you plan to stay in it). As such it’s important not only to consider your current DTI but also to project that DTI into the future to generate an estimate of where you’ll be five or ten years down the line.