Your Money_ The Missing Manual - J. D. Roth [101]
How Much House Can You Afford?
Housing is the largest expense in most families' budgets. But how much is too much to spend on shelter?
Economists have used decades of financial stats to create computer models that predict how much people can afford to spend on housing and debt. Traditionally, lenders have used what's called a debt-to-income ratio (or DTI ratio)—a measure of how much of your income goes toward debt every month—to estimate how much people can afford to borrow to pay for a home. To find this ratio, divide your monthly debt payments by your gross (pre-tax) income. For example, if you pay $300 toward debt every month on a $3,000 income, your DTI ratio is 10%. (The lower the number, the better.)
Banks and mortgage brokers look at two numbers when deciding how much to loan you:
Front-end DTI ratios (sometimes called housing expense ratios), which include your total housing expenses: mortgage principal, interest, taxes, and insurance. These four factors are often called PITI. (Yes, the mortgage industry is filled with acronyms and abbreviations.)
Back-end DTI ratios (also known as total expense ratios), which include all of the above plus other debt payments like auto loans, student loans, and credit cards.
When you apply for a mortgage, a computer checks to be sure the amount of debt you want to take on falls within accepted ranges. This process is called automated underwriting. When the computer is finished, the loan application moves to manual underwriting, where an actual person uses industry-standard DTI ratios to decide whether to approve or deny the loan.
Note
The key thing to understand about DTI ratios is that they're used to estimate the lender's risk, not yours. That is, your mortgage company uses them to check whether they think you can make the payments—not whether you can comfortably make the payments. So if you want to be able to dine out and take vacations and pursue other financial goals, the DTI ratio you use in your calculations should be lower than the one your lender uses.
During the 1970s (before credit-card debt became common), DTI wasn't split between front-end and back-end. There was only one ratio, and it was 25%. If your mortgage, taxes, and insurance costs were less than 25% of your income, people assumed you could afford the payment. (This is still an excellent rule of thumb.)
Debt-to-income guidelines have relaxed over the years. When my wife and I bought our first home in 1994, our mortgage broker told us our front-end DTI ratio had to be 28% or less, meaning we couldn't pay any more than 28% of our gross income toward housing. The back-end DTI ratio was capped at 36%, which meant that our housing expenses and other debt payments combined couldn't be more than 36% of our income.
When we bought our new home in 2004, the accepted DTI ratios had grown by 5%. "That 28% figure is old," we were told. "Most people can go as high as 33%." The back-end ratio had been raised to 38%–41% in some cases. (During the housing bubble, some lenders went still higher, even above 50%!)
A 5% increase may not seem like a big deal, but when you're talking about a house payment, it's huge. If you're earning $60,000 per year, 5% is $3,000, or $250 a month. Many people have lost their homes because they took on mortgage payments that were just $250 more than they could afford each month.
Generally, banks are happy to lend you as much money as you want. (Within reason, of course, and if your credit is good.) The recent credit crisis has certainly made lenders more cautious, but they're still not going to stop you from digging a hole for yourself if that's what you want to do. In The Automatic Millionaire Homeowner (Broadway, 2008), David Bach writes:
You should generally assume that the amount the bank