All About Ratios: Why Your Bank Thinks You’re Richer Than You Are

Several ratios come into play when it comes to figuring out what you can afford. To make things more complicated, you and your bank have different ways of figuring out what you can afford.

Let’s first talk about the bank’s method. Banks are interested primarily in two things: your debt and your income. Sometimes they will also consider your life story or your special circumstances, but these will always be secondary to your debt and income.

Here are the two primary measures with which they figure out your mortgage worthiness:

1. Housing Ratio: maximum % of gross montly income that can be used for a monthly mortgage payment

–> Translation: monthly mortgage divided by monthly income (before taxes)

–> Range: 28% (conservative) – 33% (aggressive)

2. Debt-to-Income Ratio: maximum % of gross monthly income that can be used for house payment, plus all other debts

–> Translation: monthly mortgage plus other monthly debt divided by monthly income (before taxes)

–> Range: 38% (conservative) – 45% (aggressive)

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How to figure out what you can afford, the bank way:

Use this affordability calculator, or get out a piece of paper and calculator and work it out yourself, with this guide:

1. Total Gross Monthly Income: _____

2. Total Gross Monthly Income x _0.45_ (or 0.38, to be conservative):  _____

3. Total Monthly Consumer Debt Payment: ______

4. Subtract Line (3) from Line (2): _____ <– this is your maximum house payment (Principal, Interest, Taxes, Insurance)

5. Multiply Line (4) by 15%: ______ (estimated taxes & insurance)

6. Subtract Line (5) from Line (4): _______ (maximum Principal and Interest payment)

7. Divide Line (6) by factor from this table:  ______

8. Multiply Line (7) by $1,000: ________ <–This is your maximum loan amount, according to the bank

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Your Line (8) is probably surprisingly high. That’s because the bank’s calculation does not take into account your lifestyle, the amount you put away in retirement each month, or any other financial obligations you may have.

So what should you do to figure out a comfortable loan value for YOU? My advice is to get your personal finances in order, and figure out the monthly costs that you can’t possibly cut out (things like 401k contributions, IRA contributions, a savings fund, support for a parent or child, etc) and add that to Line (3). That way you know that these costs are “protected” as part of your monthly non-housing costs.

Also, take a look at your monthly take-home pay (after taxes), and compare that to Line (4). Think about how much you’d have left to live on if Line (4) were subtracted from your pay. Reduce Line (4) to a comfortable level, and re-do your calculations in Lines (5) – (8) to get a more realistic maximum loan amount.

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Bottom line:

The more debt you have, the less house you can afford. Always remember that the bank will likely approve you for a loan that is more than you can comfortably afford. The bank does not care if you have to eat Ramen noodles for 30 years in order to afford your home–but you care! Do your own “shadow” calculations so you’re not swayed by the bank’s big number.