Author: J.D. Roth / Source: Get Rich Slowly
“How much house can I afford?” Answering this question correctly is one of the keys to building a happy, wealthy life. Unfortunately, there’s a vast housing industry in the U.S. that’s geared toward providing the wrong answer.
You see, housing is by far the largest expense in most people’s budgets.
According to the U.S. government’s 2016 Consumer Expenditure Survey, the average American family spends $1573.83 on housing and related expenses every month. That’s more than they spend on food, clothing, healthcare, and entertainment put together!Too many folks struggling to make ends meet focus their attention on fine-tuning their budget. They try to save big bucks by clipping coupons, growing their own food, and/or making their own clothes. While there’s nothing wrong with frugal habits — I applaud everyday thriftiness! — all of these actions combined won’t (and can’t) have the same impact on your budget as keeping your housing payments affordable.
Part of the problem is what I call the Real-Estate Industrial Complex, each piece of which has a vested interest in convincing consumers that bigger, more expensive homes are better. Real-estate agents, mortgage brokers, home-shopping shows, and glossy magazines all encourage folks to buy at the top end of their budget. But buying at the top end of your housing budget is dangerous.
Buying a home is a huge decision, financially and otherwise. If you’re going to purchase a place, it’s important to know how much house you can truly afford.
Debt-to-Income Ratio
Economists have used decades of financial stats to create computer models to predict how much people can afford to spend on housing and debt. Banks use these models to figure out how much they think you can afford to spend on housing.
Traditionally, lenders use what’s called a debt-to-income ratio (or DTI ratio) — a measure of how much of your income goes toward debt every month — to estimate how much you can afford to pay for a home without risk of defaulting. This might sound complicated, but it’s not.
To find this ratio, divide your monthly debt payments by your gross (pre-tax) income. So, for example, if you pay $400 toward debt every month and you have an income of $4000, then your DTI ratio is 10%. If you pay $800 toward debt on a $4000 income, your DTI ratio is 20%. The lower your debt-to-income ratio, the better.
Banks and mortgage brokers look at two numbers when deciding how much to loan:
- The front-end DTI ratio (sometimes called the housing expense ratio), which includes only your housing expenses: mortgage principle, interest, taxes, and insurance.
- The back-end DTI ratio (also known as the total expense ratio), which include all of the above plus other debt payments like auto loans, student loans, and credit cards.
The key thing to understand about debt-to-income ratios is that they’re used to estimate the lender’s risk, not yours. That is, your mortgage company uses them to check whether they think you’ll be able to make the payments — not whether you can comfortably make the payments.
If you want room in your budget for fun, you should opt for a lower debt-to-income ratio than your real-estate agent and mortgage broker say you can use.
If you’re a money nerd, you can read more about debt-to-income ratios at Fannie Mae’s website.
How Much House Can You Afford?
During the 1970s (before credit-card debt was common), DTI wasn’t split between front-end and back-end. There was only one ratio, and it was 25%. If your mortgage, taxes, and insurance costs were less than 25% of your income, people assumed you could make the payment.
This is still an excellent rule of thumb: Spend no more than 25% of your budget on housing. (In fact, this is the number that money guru Dave Ramsey advocates.)
That said, debt-to-income guidelines have relaxed over the years.
- When my ex-wife and I bought our first home in 1993, our mortgage broker told us that our front-end DTI ratio had to be 28% or lower, meaning we couldn’t pay any more than 28% of our gross income toward housing. The back-end DTI ratio was capped at 36%, which meant that our housing expenses and other debt payments combined couldn’t be…
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