Where do these numbers above come from? Most government-backed mortgages utilize the following ratios for their underwriting:
- Front-end debt-to-income ratio = housing-related costs (PITI) divided by gross income. PITI stands for principal, interest, taxes, and insurance.
- Back-end debt-to-income ratio = housing-related costs (PITI) plus all recurring monthly debt, all divided by gross income. Recurring monthly debt includes student loans, car loans, credit card debt, and alimony/child-support obligations.
Essentially, they want to be sure that housing costs don’t take over your entire budget and also that you can still handle your total monthly debt load. (Left out are things like food, transportation, other insurance, health care, etc.) Each of the major lending agencies has their own set of DTI limits, but let’s use the standard Federal Housing Administration (FHA) limits of 31% for front-end DTI and 43% for back-end DTI.
You can insert your own numbers here, but let’s use these statistics based on the average US household:
- Household income. Government statistics have the median US household earning around $52,000 gross a year, or $4,300 a month.
- Taxes and homeowner’s insurance. Depending on the survey, the national average is somewhere between $2,000 and $3,000 for annual property taxes and roughly $1,000 for annual homeowner’s insurance premiums. Together that’s roughly $300 a month.
- Credit card debt. The Federal Reserve reports the average household credit card debt to be about $7,500. The underwriting guidelines use minimum payments, so if you assume a 3% minimum payment that’s $225 a month.
- Car loans. Experian reports that the average monthly loan payments was $450 for new cars and $350 for used cars. Let’s use $400 for this exercise and assume one new car per household.
- Student loans. For households with student debt, Brookings estimates that the average monthly payment is $240.
- Current 30-year fixed mortgage rate. Bankrate and HSH report this to be about 4.25%. You can always refinance your mortgage to lower your rate as well.
20% Down Payment, 31% Front-End Ratio
Using a 31% front-end ratio, that means PITI (principal + interest + taxes + insurance) can be $1,333 a month. Taking out $300 for taxes and homeowner’s insurance, that leaves us $1,033 a month for principal and interest. With a 20% down payment and a 4.25% interest rate, that works out to roughly a $210,000 maximum loan size and $260,000 maximum total home price = 5 times gross income.
20% Down Payment, 43% Back-End Ratio
Using a 43% back-end ratio and the average consumer debt numbers from above, we start with $1,850 and take out $300 for taxes and HO insurance, $225 for credit card payments, $400 for car payments, $240 for student loans. That leaves us with $685 for the mortgage payment at 4.25%. The resulting $140,000 max loan size with 20% down payment gives a $175,000 total home price = 3.4 times gross income.
5% Down Payment, 31% Front-End Ratio
The minimum down payment amount for a FHA loan is actually only 3.5%, but you will be subject to additional Upfront Mortgage Insurance Premium (UFMIP) of 1.35% of the loan amount plus an ongoing PMI of 0.80-0.85% of the loan amount annually based on your loan-to-value ratio. Having to pay PMI means less money available to go towards the loan, so our numbers now only give us a $185,000 max loan size. With a 5% down payment, that means a total home price of $195,000 = 3.75 times gross income.
5% Down Payment, 43% Back-End Ratio
Doing the same calculation using the 43% back-end ratio which takes into account other debt payments, you end up with only roughly $110,000 max loan size and loan and total home price of $117,000 = 2.25 times gross income.
By doing this exercise, we see that someone with a car note, credit card debt, and student loans is certainly going to have a much different measure of affordability than someone without such pre-existing obligations. Perhaps there is no easy rule of thumb? If I had to, I would say that a household with “significant” debt could start at 2x their household income, while someone with very little debt could start with 3x their household income. But it shouldn’t be too difficult to use this example to get much more accurate numbers.
Most importantly, just because someone is willing to lend you a certain amount, doesn’t mean you have to take it!