Calculating how much home you can buy may sound like a very complicated thing, but it really is not! All the bank is doing is comparing your liabilities (or debt) to your money stream (income). The banks like to use a formula to compare your expenses to your income. Simply put, the formula is a ratio that tells the bank how much of your income is going towards your monthly expenses and this number is quantified in a percentage. The ratio is called debt to income ratio (or DTI) and is used to determine if you can afford the home or not.
Below are DTI thresholds for different loan types:
Conventional Loans: up to 50%
Jumbo Loans: up to 43% (can vary with some lenders)
FHA Loans: up to 50%
If your DTI is above these thresholds, in most cases you do not qualify for that mortgage in that given scenario.
Now, let’s look at it in practical terms
Say you are making $8500 (this can be one person’s income or total household income) in monthly income. And something very important: banks take gross income, which is income before taxes. To run the DTI check to your income, you would take 50% and multiply it by your income. So, in this case, you get $4,250 this means that your monthly expenses cannot exceed $4,250.
What items are considered as monthly expenses?
Answer: mortgage payment (for home you are going to buy), car loan payment, student loan payment, credit card payment, child support.
If you do not have any monthly expenses besides your soon to be mortgage, then you can use all the $4,250 towards buying a home. Or if you have a car payment of $300 then that would decrease your home buying power to $3,950.
I hope you are still with me, and if you are let’s move forward. If you are not feel free to scroll back up, it will eventually all make sense. Just need to practice a little more!
How do I figure out how much my mortgage payment will be?
First let’s define what are the different elements that make up a mortgage payment. Mortgage payment consists of 4 main components.
- Principle
- Interest
- Taxes
- Insurance (hazard or fire insurance)
- PMI or MI (Mortgage Insurance, this will apply if you are putting less than 20% down)
Mortgage payment is also known as PITI an acronym that represents all the components above.
Now let’s figure out how to calculate each part. Before we do that, we need to find a home that we like and figure out the purchase price, how much down payment we can put, interest rate (you can take an industry average) and loan term (mostly going to be 30-year fixed).
We are living in the Bay Area and it is January 2018. I will take a realistic example to paint the best picture for you.
Purchase price: $750,000 (Let’s say a 3 bedroom in the East Bay)
Down Payment: 20% or $150,000
Loan Amount (Purchase Price – Down Pmt.): $600,000
Interest Rate: 3.875%
Term: 30 years fixed
Let’s get down to the grind
Figuring out principle and interest
You must use an amortization calculator to figure out the Principle and Interest. It’s almost impossible to figure out the compounding in your head. This is easy, just google “amortization schedule” and it will give you tons of links. Once you find an amortization schedule just plug and play with the numbers you decided for your Loan Amount, Interest rate and Loan Term. I like to use the one below:
https://www.bankrate.com/calculators/mortgages/amortization-calculator.aspx
Principle and Interest = $ 2821.42
Figuring out Taxes
There are two ways to go about this:
- You can take an estimate by multiplying the purchase price by 1.25%. This is a common used number industry wide. So, in our case the Taxes would be $7500 annually. Since everything is measured in monthly terms, we would take $7500 and divide it by 12, comes down to $625/month. This step works best if you do not have a property identified yet.
- Step 2 works best if you have a property address and you want to know the exact taxes. You would find out what county the property is in and then google that county’s tax collector website. So, if the home is in Alameda County, you would google “Alameda County Tax Collector”. This will give you the website for that county, and then you will go in and do a tax search by putting the property’s address. Some county websites will ask for the property’s parcel number, in that case you would use our friend Google again to find the parcel number. Usually Zillow and Redfin will have the parcel numbers when you search a property there. And remember when you find the Tax bill, it will give you an annual premium that you have to break down to a monthly amount by dividing it by 12.
Taxes = $625
Figuring out Insurance (Hazard Insurance)
There is also a common number we use on this metric. Take .35% and multiply it by the loan amount, remember you are multiplying it by the “Loan Amount” and not the “Purchase Price”. So, .35% multiplied by $600,000 is $2100 and then we divide it by 12 to break it down to monthly bites.
Hazard Insurance = $175
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And we have arrived! We have figured out PITI (Principle + Interest + Taxes + Insurance).
Monthly Mortgage Payment = $ 3,621.42
Reverse Engineer and connecting the dots
Your Income (individual or household) = $8,500
Monthly Expenses: Car + Mortgage
- Monthly Expenses (Car Payment) = $300
- Monthly Mortgage Payment (or PITI) = $3,621.42
Your total Debt or Monthly Expense = $ 3,921.42
DTI (Debt/ Income) = $3,921.42/$8,500 = .46 or 46%
We are in business! You can buy this home!
Once again, the percentage above indicates that 46% of your total income is going towards your monthly expenses. And on a conventional and FHA loan we can go up to 50% on DTI. Hence you have some wiggle room to go up a little higher on the purchase price.
To find out what loan amounts fall under Jumbo, Conventional or FHA in your county, please click the below link. If the loan is not conforming it is considered a Jumbo Loan. In most Bay Area counties any loan amount that is above $679,650 is considered a Jumbo Loan.
http://www.loanlimits.org/california/
Note: If you were putting less than 20% down, you would have Mortgage Insurance and in our scenario above, it would be around $425/month. You can figure this out by multiplying .85% (another one of those numbers used in the industry to get an estimate) to the loan amount and then dividing that figure by 12 to break it down into a monthly amount. And then you would add $425 to the PITI, therefore increasing your Monthly Mortgage Payment.
I hope this was useful to you. Please don’t forget to leave us feed-back, so we can improve our work. Until next time folks…
