How To Differentiate Between the Maximum You Can Borrow and The Right Amount of Home
If you have ever bought a home with a mortgage, you may have experienced a bit of sticker shock when the mortgage lender told you how much you qualify to borrow. This is not uncommon given the way banks and mortgage lenders calculate your affordability level.
It is often challenging for borrowers to reconcile that number with what may be an appropriate, more conservative, and reasonable amount of money to borrow. Complicating this further is trying to understand how much of the cash you have available on hand you should use for a down payment, especially considering you’ll need to also pay closing costs and should always retain three to six months of living expenses in the form of an emergency (aka Rainy Day) fund.
For most, this is a daunting task. Thankfully, our affordability calculator generates an estimate for you based on commonly applied bank-methods that should approximate what a lender will lend you as well as provide you an estimate subject to the amount of cash you have, taking into account the aforementioned closing costs and rainy day fund.
We’ll start with a quick primer on calculating affordability from both the bank’s and our own perspective to help in discussions with your lender and set a baseline expectation when searching for homes. Next we’ll show you an example using our affordability planner and share with you ideas on how to leverage these insights.
A Primer on Affordability
There are many factors considered by a mortgage lender when you apply for a mortgage, each of these affect the interest rate, mortgage product type, and ultimately the amount for which you qualify and are ultimately granted. The process of this review is known as underwriting.
Why Do Lenders Underwrite?
Mortgage lenders are in the business of making money by lending money and earning interest throughout the lifetime of the loan (in addition to the principal amount paid back to the lender). To do this, lenders must understand their risk to ensure that the borrower has the ability to pay back the loan. To do this, lenders review the Three C’s:
Credit is a determination of the borrowers ability to pay back the loan based on the borrower’s history with debt. To confirm this, lenders will run a credit report which returns, among other things, a FICO score that whittles down the borrower’s “creditworthiness” into a single number (the higher the better).
Lenders often set thresholds for certain credit scores that can dictate the willingness to lend and interest rate. For riskier borrowers, lenders will often charge a higher interest rate to offset the risk of non-payment or default (when the borrower is defunct and unable to repay the loan).
Moving from past to present, capacity requires the lender consider whether or not the borrow can afford the amount lent. This is done by analyzing the borrowers income (both consistency and amount), other existing debts (like student or auto loans), and to a lesser degree the amount of cash available on hand and expected budget.
Collateral represents the assets that ‘back-up’ the loan, meaning if the borrower is unable to pay back the loan, the lender will instead take into possession the collateral as an alternative source of repayment. When buying a home, this means the house. If the borrower is unable to make mortgage payments, the bank may be able to take the home from the homeowner via a foreclosure.
This is why a home appraisal is an important part of the underwriting process. Lenders, unsurprisingly, are unwilling to lend more money than a home is worth, because immediately the collateral value is worth less than the loan.
Lenders consider whether or not the borrower will be treating the home as their primary residence (‘Owner Occupied’) or as a rental/investment property. Borrowers who are buying a home as their primary residence are afforded more mortgage options given there is inherently less risk than an unoccupied or rental property. A key difference for borrowers is for rental/investment properties, lenders will often require as much as 20-25% down payment and additional fees.
Similar to the home use, the property type matters. Single family homes as just as they sound - your standard family home. Condos (simplex, duplex, etc) are those with multiple units and managed by an association. These are, given the property is managed and lived in, and therefore affected, by more than one owner, considered more risky by lenders and can often mean a slightly higher interest rate than the same loan for a single family home. Other common home types include Townhomes. These are communities of similar homes, often referred to as Planned Urban Development (PUD) in lender-speak. While similar to a single family home where the owner purchases and owns the entire unit, they are managed as an association and carry similar treatment to condos. The difference is the owner is responsible for the exterior of the home as well, unlike a condo (which falls on the responsibility of the association, or collective of condo-owners).
Quick Note On Home Owners Associations
Home Owners Associations (HOAs) are the collective effort by the owners of Condos, Townhomes, and subdivision dwellers to manage the communal areas and resources of the complex. Unit owners often pay monthly HOA dues into a common fund that is used for common area maintenance, building related utilities (common area electricity, for example), and insurance, among others.
Condos are most commonly associated with HOAs given the unit owners are responsible (meaning they pay for anything related to) the interior, while the unit owners collectively are responsible for the upkeep and maintenance of the exterior, such as the roof, parking lot, and shared areas like stairwells. The rules and responsibilities of the HOAs are defined in the operating agreement and bylaws of the association and can be managed by the unit owners or outsourced to property management companies.
When underwriting and considering making an offer on a condo or HOA-associated property, lenders (and buyers) will consider the amount of money the HOA has in reserves, meaning the amount in the bank account. HOAs with little cash are more risky given that if a large expenses is needed, unit owners will need to pay out-of-pocket. On the other hand, HOAs with healthy reserves are in a better position to handle such events.
The Bank Method: Your Maximum
How do mortgage lenders know how much you can afford? How should you consider what they’re willing to lend you relative to what you can comfortably afford? Below we walk through how mortgage lenders derive the mortgage amount they’re willing to extend to help you come up with a number that may be more comfortable (as the lender is providing you the maximum).
The Basics Of Mortgage Math
Mortgage lenders derive ‘qualification’ ratios to determine your borrowing ability. These ratios are based on your income, existing debt payments, and expected total housing payment. Here’s how they work:
Maximum Mortgage Payment (The Rule of 28)
This rule uses your monthly gross income (i.e. before taxes are taken out) and caps your mortgage payment at 28% of that figure. So if your monthly gross income is $10,000, your maximum monthly mortgage payment should be $2,800, and based on the prevailing interest rates, the maximum mortgage amount is determined.
Maximum Mortgage Payment = Monthly Gross (Pre-Tax Income) x 28%
= $10,000 x 28% = $2,800
Maximum Total Housing Payment (The Rule of 32)
Next, lenders consider your total housing payment, which includes mortgage payment in addition to homeowner’s insurance, private mortgage insurance (PMI), taxes, and association fees) and caps that figure at 32% of monthly gross income. Continuing our example, this figure is $3,200, meaning you can reasonably afford no more than $500 in monthly property taxes, HOAs, and PMI. Here, HOA payments for condos come into play throughout your search.
Monthly Gross (Pre-Tax Income) = $10,000 x 32% = $3,200
Maximum Taxes + Insurance + HOAs + PMI = $3,200-$2,800 = $500
Maximum Total Debt Payment (The Rule of 40)
This rule builds in total debts, meaning auto and student loans and credit card minimums and suggests a maximum figure of 40% of gross monthly income. Our example here means $4,000 and suggests no more than $800 in non-housing related monthly debt payments. If you’re considering buying a new car or have large student loans, this could prohibit your ability to obtain a mortgage.
Monthly Gross (Pre-Tax Income) = $10,000 x 40% = $$4,000
Maximum Total Monthly Debts = $4,000-$3,200 = $800
The Homebloq Method: Your Current State of Affairs
Because Homebloq was built by home buyers, we understand the challenges of mortgage math. A hard step to take is one from “here’s how much money a bank will lend me” to “and here’s how much I should borrow” because mortgage lenders are not required or able to provide those answers. They can, and should, be able to answer your questions as it relates to the differences between mortgage products, the rate environment, what those differences mean for your upfront and monthly costs, and provide transparent answers into their own fees.
In addition to the affordability level calculated using the bank method above, we constrain that by the amount of cash available. This helps, for example, borrowers who may qualify for a large loan because they have high incomes and little existing debts, better approximate what may be reasonable if they have little cash available for a down payment, closing costs, and to retain in savings.
We always start and use a conservative down payment percentage (generally 20% for convention mortgages) and assume three months of living expenses (your estimated monthly housing payment + other monthly debt and expenses) should be retained. We also make an estimate for closing costs and factor all these in against the cash available to generate an appropriate amount to borrow and therefore home to purchase.
Below is an example and explanation for using our affordability planning tool.
Navigate to the affordability calculator on Homebloq.com and enter in the below information:
· Home Type: This is the type of home (Single Family, Condo, Other) that you desire to purchase. Condos are viewed as slightly more risky by most lenders due to the fact that common area maintenance, for example, is shared among the unit owners and some units may be rented and not maintained by the owner so we adjust for that with a slightly higher interest rate.
· Mortgage Type: The most common type of mortgage is a convention, thirty-year fixed rate mortgage, although other options do exist. Click here to learn more about different mortgage products.
· Monthly HOAs: Condo owners, most Townhome owners, and even owners of single family homes in Planned Urban Developments (subdivisions) must pay monthly dues for general upkeep and maintenance related to common and exterior parts of the home. These can range from as little as $100/month to $500 or more.
· Down Payment Percent: We always recommend putting 20% down, but realize it is not feasible for most. Lenders will often increase the interest rate available to you as your put less down to cover their risk, and these increments usually come at down payment percentages of 15%, 10%, and 5% or less.
· Annual Pre-Tax Income: This is the combined (you and spouse or other co-borrower) annual income before taxes.
· Monthly Non-Debt Expense: These are the amount you spend on average not towards your current housing (mortgage or rent) or other types of debt payments such as student or auto loans, alimony, etc.
· Monthly Debts (Non-Housing): The amount of other debt payments made monthly such as student or auto loans, alimony, etc.
· Total Cash Available For Purchase: The available cash for the purchasing your home. This could reflect the amount available in your savings or whatever funds you will be using to contribute to your down payment and closing costs.
Understanding and Using the Results
The below is an example output for a household using a standard thirty year fixed-rate mortgage on a Single Family Home and 20% down with annual household income of $75,000, monthly Non-Debt spending of $800, other debt payments totaling $250/month and available savings of $50,000:
Estimated Based on Income, Expenses, Debts, and Cash Available
This is the aforementioned affordability estimate constrained by the cash available. In this example, the borrower’s “lower-limit” is around $200,000 in home amount. This requires a mortgage amount of approximately $160,000 equating to a monthly total housing payment of $1,195.
Note: Due to the fact the borrower is putting down 20%, there is no private mortgage insurance (PMI). This monthly fee applies when borrowers put down less than 20% and is required until the borrower has paid down the mortgage amount to meet 20–22% equity in the home.
We estimate a required savings amount of at least $46,850 which includes closing costs of approximately $4,000, a down payment of about $40,000 and a rainy day fund of at least $3500.
You can re-run as many iterations as necessary to get a sense of how changes in down payments, expenses, and mortgage products affect this value, but this should establish a reasonable lower-limit to your affordability planning.
Estimated Based on Income, Expenses, and Debts
On the other hand, only considering the borrower’s income and existing debts, a purchase price of nearly $290,000 is obtainable (a $90,000 increase or 45% more!). This requires a mortgage amount of about $230,000 with monthly total housing payment of $1,750 and required cash available of just over $68,500. As you will see, given the higher mortgage amount, closing costs and living expenses increase, requiring a larger rainy day fund and cash amount to purchase.
Questions? Don’t hesitate to reach out to us at [email protected]!
The affordability calculator is intended for planning and educational purposes only. The output of the tool is not a loan offer or solicitation, nor is it financial or legal advice. Talk to a lender to find out exactly how much home you can afford.