There is perhaps no more exciting venture than buying a home, which will be the foundation of your life for years to come. Whether your dream is a large ranch house in Victoria, Minnesota or a townhome in St. Louis Park, all buyers follow a similar formula for calculating how much home they can afford. In the tips below we'll provide insights about each of the relevant variables that affect home affordability.
Understanding your debt-to-income ratio
When you are pre-approved for a loan by your mortgage loan officer, they will review your financial and credit history and calculate your debt-to-income ratio. This ratio analyzes how much of your income you will spend to pay your monthly debt.
The front-end ratio calculates how much of your monthly income can responsibly be used for your mortgage principal and interest, and property taxes and homeowner's insurance (PITI). You can calculate your own front-end ratio by dividing the estimated PITI by your gross monthly income. Lenders advise your front-end ratio be between 28 and 31 percent of your gross monthly income.*
Your back-end ratio measures how much of your gross monthly income is needed to cover your PITI plus the rest of your monthly debt obligations. These additional obligations can include car loans, student loans and child support payments.
Your mortgage loan officer will calculate your back-end ratio by adding up your PITI and monthly debt payments, then dividing that total by your gross monthly income. Lenders prefer your back-end ratio be between 36 and 42 percent of your income.*
Get more details on calculating your debt-to-income ratio.
Down payment savings
Saving for a down payment is a big part of home affordability, especially for first-time homebuyers. In general, lenders look favorably upon buyers who have saved a down payment, but in many cases a 20 percent down payment is no longer needed to secure a home mortgage loan.
Down payments for FHA loans
Buyers securing an FHA loan can now put as little as 3.5 percent down when buying a home. FHA loans are backed by the Federal Housing Administration and they are designed for homebuyers who have enough to pay monthly mortgage commitments, but may not be able to save for a large down payment.
The "catch" of these loans is that they are helper loans, so they have a maximum loan amount that depends on the county where the loan is originated. In short, you probably can't buy a five-acre estate using an FHA loan, but you can purchase a great starter home in almost any area.
Get more information about FHA loans, down payments and loan limits.
Down payments for conventional loans
Earlier this year, Fannie Mae and Freddie Mac announced they would approve conforming loan mortgages with down payments as low as 3 percent for borrowers who offer full financial and income history, undergo homeownership counseling and have a credit score of 640 or higher. These conforming loans also have loan limits, so borrowers will need to stay under $417,000 in both Minnesota and Wisconsin.
If you're hoping to borrow more than $417,000, you'll need to secure a jumbo loan, which will require a higher down payment and additional financial indicators. Your mortgage loan officer can provide details and insights about what is needed to secure a jumbo loan.
Get more information about conventional conforming loans and jumbo loans.
Down payments for VA loans
VA loans, which are backed by the Department of Veterans Affairs, do not require a down payment.
How are down payments tied to affordability?
Loan limits are for the total amount borrowed, not the total amount of the home purchase. If you have a down payment savings of $20,000 and are securing a conforming conventional loan (which has a loan limit of $417,000), you can technically look at homes priced at up to $437,000.
Mortgage interest rates
Mortgage interest rates also greatly affect affordability. The lower your interest rate, the more home you can afford because you will pay less interest per month and over the life of the loan. While interest rates have remained low for the last several years, experts predict that interest rates will rise to 5 percent by the end of 2015, which could lower homebuyers' purchasing power.
How do interest rates affect buying power?
Imagine for a moment that you are a homeowner approved for a 4 percent interest rate on a 30-year, fixed-rate conforming loan of $250,000. In this case, your monthly mortgage payment would be about $1,190 per month.
If your interest rate rose to 5 percent, but all other factors remained identical, your monthly mortgage payment would increase to about $1,340 per month. That's a difference of $1,800 annually and $54,000 over the life of the loan.
The hottest trend: responsible homeownership
By understanding what factors lead to high affordability, you are one step closer to becoming a responsible homeowner. We encourage you to explore your options using this affordability calculator. Remember, this calculator should be used to see how your debt, finances and current rates could affect your buying power—but the only way to know for sure is to get pre-approved by a mortgage loan officer. Reach out today to start the buying process. And don't forget to share your real estate experiences with us on Facebook, Twitter, Instagram and Google+ using #BuyerInsights and #SellerInsights.
*DISCLAIMER: There is NO WARRANTY, expressed or implied, for the accuracy of this information or its applicability to your financial situation. Please consult your own financial advisor or mortgage loan officer to determine your individual buying power.