Understanding FHA Loans and Minimal Down Payments
How much home can you afford using a minimal down payment like an FHA loan, only putting 3 1/2% down, if you have a salary and you make somewhere between $50,000 and $75,000 per year? Well, that's exactly what we're going to dive into in today's article. Now, this article isn't to tell you that's how much you can actually afford.
It's an article showing you how a lender is going to calculate based on your income and your debts the number that you're actually pre-approved up to. It's up to you to figure out whether or not you can.
Income Calculations for Homebuying Affordability
So with that said, we're going to do some income calculations. We're going to calculate mortgage payments based on a couple of different purchase prices using today's interest rates. Now, something to understand: interest rates change every single day on every single type of loan program depending on what happens with mortgage-backed securities as well as the overall market. So just because I'm giving you an interest rate here doesn't necessarily mean that's going to be your interest rate. In fact, interest rates are actually affected by more than 40 different factors. So understand, in this article, we're using calculations based on having good credit, right? Not perfect credit, good credit somewhere above, say, 700, 720, and we're going to be talking about FHA loans.
Now, the reason we're talking about FHA loans is because FHA loans are typically the most flexible loans when it comes to qualifying for a home, especially when we're using a minimal down payment like 3.5%. Yes, conventional will allow you to put only 3% down, but to be completely honest, the payment is likely going to be less on an FHA loan than it is on a conventional loan with that minimal down payment. So we're going to be talking about FHA because not only is it lenient with regards to credit, it's also the most lenient when it comes to debt-to-income ratio because it allows you to qualify for more home with more debt. That's because conventional only allows you to have a max debt-to-income ratio if you're kind of a perfect candidate, if you will, of around 50%, whereas FHA will allow you to go to 57%.
Exploring Debt-to-Income Ratio: What You Need to Know
"I don't even know what debt-to-income ratio is, what does that actually mean?" Well, one of the things the lender is going to do when qualifying you to buy a home is they're going to look at your gross monthly income. That is your income before any taxes are taken out. Now, if you're a W2 employee, you're an hourly employee, basically, you can take that W2 that you receive at the end of the year, your W4 form, and you can divide it by 12 to get your gross monthly income. Now, it is an average over a 2-year period of time, which is a conversation for another day. But essentially, what they do is they take that gross monthly income.
So, in the case that you make $50,000 per year, they take that number and they divide it by 12, and that's because there are 12 months in the year, which gives you a gross monthly income of $4,160. Now, I know a lot of people watch this video and go, "Jeb, why are they using that number? Because I actually pay taxes. I pay money into my 401k. I don't actually take home that number." Well, that's the main reason because people pay different amounts of taxes based on their exemptions, based on where they're putting money, based on garnishments in some cases, which means everybody takes home a little bit different. So what they like to do is take the gross monthly income and use that number.
Now, it's up to you to have a budget and understand how much you can afford. That's why I started the article by saying, "Hey, I can't tell you how much you can actually afford. I can only show you how the lender is going to calculate this." So in the case that you make $50,000 per year, that means they're using a number of $4,160. Now, when it comes to being self-employed, it's a little bit different because self-employed borrowers have different write-offs, and just because they make $50,000 a year doesn't mean they necessarily report $50,000 per year, and that can be a problem. And so that's why if you're at home trying to do these calculations, use this as more of a novelty-type article, an educational article to get some basic calculations. Don't do the numbers here and run with it and not get pre-approved and try to buy a home. You need to go through the process. You need to talk to a professional, someone that can analyze your tax returns, analyze your credit report, and tell you exactly how much home you can afford to purchase.
But in the case that you make $75,000 per year, that was our other number that we were using. We were using 50,000 and 75,000. So, they take 75,000, they divide that by 12, which gives you a gross monthly income of $6,250. So we know our gross monthly income at $50,000 is $4,167. We know what it is at 75,000. That's $6,250. If you're somewhere in between that, if you make somewhere between 50,000 and 75,000, you can do a basic calculation and figure out your income from there.
As part of this process, not only is the lender looking at your income, they're also looking at your monthly debts. They're looking at whatever debts show up on your credit report. Now, things that don't show up on your credit report, you know, things like child care, things like your grocery bill, your gas bill, those aren't calculated into your debt-to-income ratio. They're only taking things that report on that credit report: things like your car payments, credit card payments, student loan payments. So any sort of revolving debt, any sort of installment debt that shows up on that credit report, they're going to factor into your debt-to-income ratio.
So, your debt-to-income ratio is made up of a front-end ratio and a back-end ratio. The front-end ratio is just your housing expenses, your proposed housing expenses, the new house that you're trying to purchase. And what goes into that is the principal, interest, taxes, and insurance, along with the property taxes, any homeowners insurance you have to have on that property, and if you're in a property that has an HOA, the HOA is also factored into that. So it's your total housing expenses. It's the front-end ratio. The back-end ratio, which is really where FHA is the most flexible and allows you to go to a 57%, well, that takes all the housing expenses on the front and then they add that monthly debt that shows up on your credit report, and then that number makes up your back-end ratio, which can't exceed 57%. But it's important to note that even though FHA allows you to go to a 57% on the back end, they have a cutoff on the front-end ratio as well. You can't have more than 47% of your gross monthly income going towards housing expenses.
Now, in the case that you don't have any debt, then your front-end ratio and your back-end ratio are essentially going to be the same, which means if you didn't have any debt, then you're going to have a 47% front-end ratio and a back-end ratio of 47%. But in the case that you have some debt, then your front-end ratio is going to be maxed at 47%, and then once you add those debts in there, it can exceed 57%. Now, we'll do some basic calculations in here to help you understand what that means.
One of the things that comes up with FHA all the time is that FHA loans are just for first-time homebuyers. That's not true. You could have had an FHA loan in the past and get a new FHA loan. In fact, you can have an FHA loan now and also get another FHA loan, assuming you meet the qualifications to do so. Now, in the case that you're buying units with FHA, not only are they going to use your income that you're making, they're also going to allow you to use 75% of the units that you're purchasing income in order to help you qualify.
So that income is going to be combined with your income, and then all of the calculations that we talked about today essentially are the same. Now, we're not going to get into that in this article. We're primarily today talking about the purchase of a single-family residence, the purchase of a condo, if that's what you're looking at using an FHA loan with its 3.5% down. And we're also using the salaries that we talked about in today's articles, at 50,000 and 75,000. But in order to keep this article somewhat timely and not a long, extensive article, I'm just going to do some basic calculations. We're going to run over some numbers at both of those salaries to see what you would qualify for today based on today's interest rates.
Front-End and Back-End Ratios: Key Factors in Loan Approval
Now, earlier in the article, we broke down our gross monthly income. Now, I just want to take a minute here and talk about front-end ratio and back-end ratio because FHA has that max 47% front-end ratio. We know that your housing expenses cannot exceed 47% of your gross monthly income. So, in the case that you make 50,000 per year, and they're using a calculation of $4,160, we know that your front-end ratio cannot exceed $1,958 on your housing expenses. Now, your back-end ratio can be as high as $2,375, which means in the example that we're going to use today, you can make $50,000 per year, have around $417 of monthly debt showing up on your credit report, and these numbers actually apply to what we're talking about. Now, as I mentioned earlier, don't use these numbers and run with it. Talk to a mortgage professional. Have them look at your situation, run all the numbers, and confirm that the numbers are accurate. There are so many nuances in the mortgage process that can keep you from qualifying, or they may be able to add some more income back to your income and help you qualify for more. So, it's super important to make sure you're working with a professional.
When it comes to the $75,000 salary, you're bringing home $6,250. Well, 47% of that number, your max housing expense ratio, is going to be $2,938, whereas your back-end ratio is going to allow you to go to $3,568. In this case, your housing expenses can't exceed $2,938, but you can have somewhere around $625 or so in monthly debt, and you might still be able to qualify for this loan.
Now, understand, when you're going to that max debt-to-income ratio of 57%, not everybody is going to get that ratio, right? You need to have higher credit scores, you need to have compensating factors, maybe some additional money in the bank. You can't be the borrower meeting the minimum qualifications of FHA loans, which allows a 3 and a half percent down payment with as low as a 580 credit score. If you're that borrower, you're not going to be able to likely get the 57% max debt-to-income ratio, which means you're likely going to qualify for less. All the more reason to make sure you're working with a professional when you're going through that pre-approval process just so they can run the numbers and make sure that the information you're getting is accurate.
Debunking Myths: FHA Loans and First-Time Homebuyers
But in the case that we say, "Can you qualify for a $350,000 home with a $50,000 salary?" Let's take a minute here and break down what those numbers look like. Now, when you're buying a $350,000 home, something to understand with FHA is they only require that 3.5% down payment, which in this case is $10,500, which means you would have a loan amount of $289,500. But something to understand about FHA loans is they have something called upfront mortgage insurance. You can't avoid this. Every single FHA borrower, regardless of their credit score, regardless of how much money they're putting down, has upfront mortgage insurance. Now, you can choose to pay for it outside of escrow if you want, or you can finance it into the loan amount. Most people just finance it into the loan amount because it only adds a little bit more to their monthly payment versus coming up with that money out of pocket.
But with that said, it's 1.75% of that loan amount. So, in this case of $289,000, if you multiply that by 1.75%, that gives you $5,066. Once you add that back to the $289,500, your base loan amount is $294,500. That's at 6 and a quarter percent. Understand, there's somewhere in that range, but also understand, this year, interest rates are likely going to continue to go down. So, if we're talking about 6% interest rates today, as interest rates come down, you're likely going to be able to qualify for more homes, which means housing affordability is going to improve a little bit. So, if you can qualify for the numbers based on today, or maybe you're a little bit short, well, as interest rates come down, that's going to improve that scenario for you and maybe make it a little bit easier to qualify. But with that, we said interest rates today, we're using 6%, which means based off that loan amount of $294,500, which is roughly what it is here in California, but the nationwide average is 1.1%, which means your property taxes are going to be $275 per month. On top of that, you're going to have monthly mortgage insurance. That's one of the downsides of an FHA loan.
Not only do you have the upfront mortgage insurance, you also have monthly mortgage insurance, which stays on the loan for the life of the loan. You can never get rid of the mortgage insurance unless you put at least 10% down when you do that FHA loan, which in that case, it doesn't even fall off until after year 11. And most people buying using an FHA loan aren't putting 10% down. They're putting the 3 and a half percent down option, which means that mortgage insurance is going to be on the loan for the life of the loan. There's no way to avoid this. Every single borrower, regardless of their credit score, regardless of how much money they're putting down, is going to have mortgage insurance, at least for the first 11 years. Now, you can refinance out of this loan and get rid of that mortgage insurance at any time you want, as long as you have enough equity in that property and you go into, say, a conventional loan or another type of loan.
Because if you go back into an FHA loan, you're going to have mortgage insurance again. But the mortgage insurance is 0.55% when you're putting just 3 and a half percent down. So, in the case of the numbers that we're talking about here, that's $135 per month. In addition to that, you're going to have to have property insurance, which covers your property from fire, from theft, that sort of thing. Now, this is also one of those numbers that can vary considerably depending on where you're located in the country. Areas like Florida, areas like parts of California, now property insurance has gone up considerably. But I'm going to use the number of around $100 per month, which is $1,200 per year in homeowners' insurance, which I think would cover a $300,000 home. So, in this case, we're using $100. So, if we added all those numbers together, that gives you a total monthly mortgage payment of $2,276. So, in the case that you make $50,000 per year, remember, our max front-end ratio is 47%, which means we could not exceed $1,958 on our housing expenses. Well, the housing expenses here are $2,276, which means we're not going to be able to qualify for a $300,000 home putting just 3.5% down if interest rates are at 6% using an FHA loan. We're going to have to go to a lower-priced home or interest rates are going to have to come down or we're going to have to put more money down. So, $300,000 is out of the question.
So, how much could you actually afford? Well, if you run those same numbers on a $250,000 home, your 3.5% down payment would be $8,750. Now, once you add that upfront mortgage insurance premium back onto the loan, which in this case is $4,220, your base loan amount is $245,400. Well, the interest rate again is 6%, that gives you a mortgage payment of $1,472. On top of that, you're going to have your property taxes. Again, we're using 1.1%, because that's the nationwide average. That's $229 per month. In this case, your mortgage insurance would be $113 per month, and in this case, we're keeping the property insurance at $100, which gives you a total monthly mortgage payment of $1,913. So, in the case that you have zero debt and you make $50,000 per year, you're under that 47% threshold of $1,958 because the payment is $1,913. In fact, you can have up to $417 in monthly debt and likely still qualify for this loan, assuming you meet all the other qualifications of FHA.
Now, we're going to talk more about the $75,000 of income. How much could you go up to if you made $75,000? Well, we said their max front-end ratio in this case is $2,938, whereas we can have a back-end ratio of $3,563. When we talked about the $300,000 home a moment ago, we said that that total mortgage payment was $2,276. So, in that case, you would qualify on the front-end ratio and be able to have monthly debts of over $1,200 and still qualify for that loan. But let's say what are your max qualifications at $75,000? Well, let's take a look at a $350,000 purchase price. So, in the case of $350,000, you're putting 3.5% down. That's $14,000, which means we're financing $336,000 before the upfront mortgage insurance. The upfront mortgage insurance is $5,880.
Once you add that back to the base loan amount, that's $341,880. Well, at 6%, your mortgage payment would be $2,051, and on top of that, you'd have your $275 of monthly property taxes. Then you'd have your monthly mortgage insurance of $156. On top of that, you'd have your monthly property insurance of $100, which means your total monthly mortgage payment is $2,582. So, in the case of someone that makes $75,000 per year, as long as you didn't have more than $1,595 in monthly debt showing up on your credit report, you could afford a $350,000 home using a 3 and a half percent down payment with an FHA loan.
Also Read: Canadian Housing Crisis - My perspective
Summary and Next Steps
So, hopefully, this article was helpful to you. I know it's a long article. I know it's a lot of information to take in, but I just wanted to help you understand, based on your income and your debts, how a lender is going to calculate how much you could potentially qualify for a home.