First of all, just because you can buy the McMansion on the big lot with the bathtub shaped like a clam and the all-red billiard room with the stuffed camel doesn’t mean you should. We’ve all known people who’ve bought more house than they could truly afford, thinking the house was going to be a giant piggy bank, featuring hot and cold running home equity loans thanks to never-ending appreciation.
Well, we all know how that turned out.
Here are some basic concepts you need to be familiar with when deciding on your home-hunt budget:
Lenders look very carefully at ratios, and this is one of the key ones. Your front-end ratio is simply your total monthly housing expenses, divided by your total monthly gross income. That’s your income from all sources, including wages, investment income, royalties, child support, alimony, and anything else you can think of that the bank figures is reliable.
So how do they define “housing expenses?” Usually by the acronym PITI (pronounced “pity” by the banking pros). PITI stands for Payment, Interest, Taxes and Insurance.
Here’s how it goes down:
You go to the bank and apply for a loan. You turn in an application, along with a few years worth of tax returns and other documentation verifying your income. (Yes, banks verify your income nowadays. It’s the darnedest thing!)
Then the lender looks up the house you’re looking at, if that’s been determined yet – or at least the mortgage you’re applying for – and adds up all the monthly outflows likely arising therefrom.
That’s going to be more than just the principal and interest payment. They also know you need to carry homeowners insurance, and unless you are putting down at least 20 percent, they’ll also throw in a percent or so for PMI, or primary mortgage insurance. They’ll also take into account probable fire and flood premiums, homeowners association dues, taxes in your area and anything else directly associated with carrying the property, and total it up.
According to guidelines published by the Federal Housing Authority, to qualify for an FHA loan, you can have a front-end ratio of no higher than 29 percent. That means your housing costs, all combined, should consume not more than 29 percent of your gross income.
It’s a mathematical equation – and underwriters are prohibited from getting too cute or creative with it. The numbers don’t lie. If you want the home, you’re going to have to come up with a bigger down payment. Get over 20 percent and you can save some money on PMI.
The Back-end Ratio
The second hurdle you have to clear is the “back-end ratio.” This ratio also takes your total debt picture into account. It’s not rocket science: The bankers start with your PITI, and then add in your debts. What’s included?
They then divide the sum of all your recurring monthly obligations by your gross monthly income.
The hurdle: 41 percent. That’s the current guideline from the Federal Housing Authority.
So you can do the math yourself. Here’s how it works:
If you and your spouse both earn $60,000 per year, the two of you together are bringing in $10,000 per month. If your monthly debt payments are $4,000 per month, you’ve got a back-end ratio of 40 percent.
You’ve just barely made the cut, in theory.
But theory and reality are two different things. In reality, to get the best available loan terms, you want to be under 36 percent on the back end ratio. You can get away with more, though, if you have stellar credit.
Are you a veteran? Great! You don’t need a down payment, and you don’t have to pay PMI. The government guarantees your loan against default (and they willcome after you if the loan goes bad). But otherwise the front-end and back-end guidelines for VA loans are similar to FHA guidelines.
Are you able to save?
You can technically get into an FHA loan with 5 percent down, and there are some special programs out there that can help you go even lower, though you’ll be paying PMI for a long time. If you’re a veteran, it is true that you don’t need a down payment at all.
But stop and think: If you don’t have enough scratch to put something down, that’s telling you something important – your spending habits are out of whack, or your debt is too high, or your underearning.
Whether you choose to put something down or not, you should have about 6 months worth of emergency expenses in the bank. If you can’t do this, chances are you aren’t ready to buy that house yet. You have some more work to do.