Debt To Income Ratio: How Much House Can You Afford?
There has been a shortage of homes for sale for the last few years. This is a trend I predicted would get worse back in 2018. My prediction has been correct, and now the Covid-19 pandemic has greatly accelerated this shortage for a whole host of reasons. In July, we had the lowest inventory of homes for sale in 38 years. One stat that shows how much the pandemic has worsened the problem is total for-sale inventory was down 29.4% from a year earlier (as of Sept 12th), and there is currently only about a 3-month supply. This supply/demand imbalance is leading to significant price increases. The median home price nationwide has risen 8.5% in the past year, effectively wiping out the increased purchasing power that buyers would have gained from lower interest rates.
This article’s point is many folks may be tempted to overspend on a new home purchase, which begs the question: How much home can you afford?
Your mortgage broker needs to know two things in order to tell you how much you can borrow: your income and your recurring monthly debt obligations. These two numbers are used to determine your Debt to Income Ratio (DTI). Your DTI includes all loan payments, such as minimum monthly credit card payments, student loans, personal lines of credit, auto loans, and your housing payment—Principal, Interest, Taxes, and Insurance (PITI).
Your maximum loan amount (based on your DTI ratio):
The proportion of your income that can apply to debt service varies by loan type. The hard cap for most loans is 50%, but loans under 45% are more likely to receive appraisal waivers and faster underwriting turnaround times. The more risk presented to the underwriter, the more diligent they will be.
Can you really afford that much house?
The question you should be asking before you take out the biggest mortgage you can qualify for, is: Can I really afford to spend 45% or more of my income on debt service? That percentage may seem manageable in theory because a banker approved it. However, the regulators that set the DTI caps (Fannie Mae and Freddie Mac) are not looking at your entire financial picture. Dozens of personal finance considerations may affect the percentage of your income that you can afford to devote to mortgage payments. Do you have one dependent or several? Do your kids go to public or private school? Will you or other immediate family members have significant healthcare expenses now or in the future? What if you need to take care of an aging parent? The lending criteria does not factor any of that into the equation. Homeowners who borrow close to the maximum are much more likely to get into financial trouble when life does not go according to plan.
A friend of mine was looking for a house in the $800,000 price range. He applied for a pre-approval letter with a lender and found out he could qualify for a $1.2 million house. Guess what? He ended up buying a $1.1 million house. Can he afford it? I don’t know in his case, but in general, when people buy too much house, other financial priorities get squeezed out. These other priorities may include those items that make life fun and memorable such as travel and experiences, or financial needs such as life insurance, retirement savings, college savings, emergency fund, etc.
A more prudent DTI ratio is specified in the 28/36 rule, which dictates that you should not spend more than 28% of your gross income on housing and a maximum of 36% on all debt payments. I would also strongly recommend that you learn to track your expenses with a good household budgeting program if you are at all worried about home affordability.
The moral of today’s newsletter is: Just because you can qualify to buy the Taj Mahal does not mean you should. Besides, if you spend too much on the mortgage, you may not be able to afford the gardener or cleaning lady…and some of us are not well suited for manual labor. ?