How Debt Affects Your Home Purchase
Most people have some form of long term debt and it matters when buying a home.
Throughout this series of posts, we have been often referencing the front-end debt-to-income ratio, with the limit of spending no more than 28% of your income in housing costs. It helped us calculate the theoretical maximum you can afford and how to make plans to achieve very high savings.
In our last post, we considered the effects of a lower down payment in your speed to buy and purchase power, since the Private Mortgage Insurance (PMI) you pay consumes some percentage of the 28%.
There’s another important factor which we mentioned earlier: the back-end debt-to-income ratio, which is often limited to 36% of your income before taxes. To calculate it, you add not only your monthly housing costs, but also any other recurring debt payments you might have, such as student loans, auto loans & credit card payments.
The first thing that can be observed: since out of the 36% you are limited to 28% in housing costs, you have 8% left for other debt. What happens when you are paying more than 8% of your income in debt? Your purchase power limit gets decreased by that much.
Example: Brad has recently leased a new car and will be paying $350 a month for it. He also has a $560 monthly payment for loans he took to pay for his undergraduate and graduate degrees. These payments represent 9.1% of his monthly income of $10,000 (before taxes).
It’s easy to see the numbers here. If Brad can’t go over 36% in recurring payments and 9.1% are already committed to the lease and student loans, then only 26.9% remain for housing. That 1.1% reduction from 28% is equal to how much the non-housing payments exceed 8%.
All in all, having other debt higher than 8% of your income does not immediately disqualify you from obtaining a loan for a home purchase, but it does reduce the maximum you can afford.
A second thing that can be observed: making advance payments toward the principal of your existing loans will not immediately help with your purchase power. If you make ten advance payments now, then you will finish paying off the loan ten payments earlier, but the monthly payment is still the same, so the same percentage of your income is still committed to that debt. On the other hand, refinancing and other means of lowering your monthly payment do affect the maximum you can afford.
Back to the example: Brad got a lender to help him refinance his college debt such that his monthly payment is now $400. Adding to that is the $350 lease, for a total payment of 7.5% of his income.
Now Brad can stay below the 8% line, so he’s back to being limited only by the front-end ratio of 28%. His maximum purchase power has increased by about 4% from $554,336 to $577,004. In a competitive scenario, this can mean the difference between been able to afford the home he fell in love with or not.
A final thing that can be observed: most people already have some form of long-term debt, so there’s a good chance that they might hit the 36% limit before than the 28% limit. Remember when we talked about the 1x-4x-5x goal before? It’s an “ideal” goal for savings, but the “practical” reality is that most people end up buying a home that isn’t 5x of their annual gross income, but rather 2.5x to 3.5x, particularly due to how that debt reduces the home purchase power and to avoid being overburdened by it.