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Calculating the Maximum Affordable Home Sale Price


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TERMINOLOGY

Home sale price is the price a home buyer must pay in order to buy a home. This includes the value of the mortgage and the amount you have to pay out of pocket. Before you can be approved for the mortgage, the mortgage lender will calculate your maximum affordable home sale price. This number represents what kind of mortgage you would realistically be able to repay. This is designed to decrease the chance that you might wind up defaulting on your mortgage, which costs the lender money and forces them to foreclose on your property to try to recoup the losses.

Calculating Affordability

The lender calculates how much you can afford using three rules - income rule, debt rule and cash rule. Some mortgage lenders will use only one of those rules, but this can result in faulty estimates. This is why any mortgage lender worth it's salt will use all three rules. Whichever result is the lowest is your maximum home sale price.

It should be noted that none of those results are set in stone. If your income or debt changes, the results will change, and you will be able to reapply for a mortgage loan again.

Income Rule

The income rule states that your monthly housing expense (MHE) cannot exceed the payment-to-income ratio. The monthly housing expense is the sum of mortgage payment, property taxes and your homeowner insurance premium. The payment-to-income ratio is set by the lender. It can be anywhere between 28-33 percent, depending on how much risk they are willing to take with you. This, in turn, is determined based on your income and credit score.

Under this rule, the maximum affordable sale price is determined by calculating the maximum mortgage payment and figuring out the value of loan it will support for the duration of the loan repayment period. The maximum mortgage payment is calculated by multiplying your total monthly income by the payment-to-income ratio and subtracting taxes and insurance payments.

Debt Rule

The debt rule states that your total housing expense (THE) cannot exceed your debt-to-income ratio. THE is the sum of your MHE plus your monthly payments on any of your existing debt. This includes any kind of debt on any type of loan you still haven't repaid. The debt-to-income ratio is set by the lender and it usually doesn't exceed 36 percent.

Under this rule, the maximum affordable sale price is determined similarly to above, by calculating the maximum mortgage payment and figuring out figuring out the value of loan it will support for the duration of the loan repayment period. However, the way the maximum mortgage payment is calculated is somewhat different. Instead of multiplying the income by payment-to-income ratio, it multiplies the income by debt-to-income ratio.

Cash Rule

The cash rule states that the borrower must have cash sufficient to make the down payment and pay other settlement costs - the fees the mortgage lender charges for all the legwork it has to do to prepare your mortgage.

Under this rule, the maximum affordable sale price is calculated by taking the percentage of the down payment and other settlement costs relative to the sale price and multiplying it by the amount of cash you have available.

Maximum Affordable Sale Price and Your Mortgage

When looking at the maximum affordable home sale price, it is important to remember that the price represents how much you can afford under the best possible conditions. For example, it assumes that your income will not go lower than the number used to calculate the price - or, at the very least, that it will stay constant. As the current recession has shown, this won't necessarily be true. This is why your best bet is to treat the number as the upper threshold and apply for a somewhat less expensive mortgage.