Banks typically use two key ratios in determining how much home you can afford to buy.
The first ratio is the front-end ratio. This is the principal & interest of the mortgage plus taxes & insurance. Banks typically look for this ratio to be less than 28% of your gross income – although some banks allow for higher amounts.
The second ratio is the back-end ratio. This includes all the components of the front-end ratio above as well as any other debt payments. This ratio usually needs to be under 36% of your gross income. Again, some banks will go higher.
However, you should ask yourself just how much are you comfortable with. The banks’ lending standards are based on models that determine the likelihood that you can make your payment. Period. These models are not built to determine a mortgage payment that ensures you are comfortable – as many people found out during the financial crisis or even more recently.
Consider two families.
Example 1 - $10,000 monthly gross income, family of 6
Deduction: $2,500 taxes/deductions, $500 small employer healthcare
Net Income: $7,000
Expenses: $1,000 groceries, $1,000 charitable giving, $3,000 other expenses
Available for mortgage: $2,000
Example 2 - $10,000 monthly gross income, family of 3
Deduction: $2,500 taxes/deductions, $100 large employer healthcare
Net Income: $7,400
Expenses: $400 groceries, $0 charitable giving, $2,000 other expenses
Available for mortgage: $5,000
In both cases, a bank might tell both families they can afford $2,800/month
In the first case, the bank will likely lend them more than what would be comfortable and in the latter the bank will lend much less than what they could technically afford.
Disclaimer: Alex Voorhees and Reston Wealth Management do not provide legal, accounting, realty or tax advice. This information is not intended to be a substitute for specific individualized legal, realty or tax advice. We suggest that you discuss your specific situation with a qualified investment, tax or legal advisor and/or licensed realtor. The opinions voiced in this article ae for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) or strategies may be appropriate for you, consult your financial advisor prior to implementing a strategy. No strategy assures success or protects against loss. You should consider the investment objectives, risks, charges and expenses of any investment carefully before investing.