It’s easy to see why you’d want to buy a house in Denver. With the stunning mountain landscapes, awesome outdoor activities, and progressive-minded community, it’s no wonder U.S. News ranked it the second best place to live in the U.S. (1)
There’s only one problem: price.
Since everyone is flooding to Denver, the demand for real estate is outweighing supply, resulting in housing expenses that are 34% higher than the national average. (2)
That means if you’re thinking about buying a house, it’s more important than ever to accurately determine how much you can actually afford. Fortunately, it’s a pretty straightforward calculation that can be done in 5 steps.
So grab a pen, paper, and calculator—and let’s get started!
Step 1. List Out Your Monthly Debts
To start, we need to figure out how much monthly debt you currently have.
List out all the monthly payments you make that would show up on your credit report—things like student loans, car payments, credit card minimum payments, child support, and other loans.
If it’s not something that would show up on your credit report (rent, cell phone, subscription services, etc.), don’t worry about it.
Once you have your list, add them up and circle the total. We’ll come back to this number in a second.
Step 2. Calculate Your Back-End Ratio Max Payment
Mortgage lenders use two numbers to determine the maximum mortgage payment you can afford—the front-end ratio and the back-end ratio. The industry standards for these ratios are 28% and 36%, respectively, but can vary from lender to lender.
For the sake of simplicity, let’s use the standard ratios. To figure out your back-end ratio max payment, grab that calculator.
First, divide your annual income by 12. Then multiply it by the back-end ratio (36%). Finally, subtract your monthly debt.
So, for example, if your annual income is $80,000 and monthly debts are $700, your back-end ratio max payment would be: $80,000 divided by 12, multiplied by 0.36, minus $700. That equals $1,700.
Now let’s compare that to the front-end ratio max payment.
Step 3. Calculate Your Front-End Ratio Max Payment
Still with me? We just have one more calculation to go.
To figure out your front-end ratio max payment, simply divide your annual income by 12, then multiply by the lender’s front-end ratio. So continuing with the above example, this would be: $80,000 divided by 12, multiplied by 0.28. That equals $1,866.
So now we know our back-end max payment is $1,700 and our front-end max payment is $1,866. Moving on.
Step 4. Build A Budget Around The Lesser Max Payment
Lending decisions are made based on the lesser of these two maximum monthly payments. So, in this case, it’s $1,700.
Knowing that $1,700 is our maximum mortgage payment, we can now figure out what housing prices, down payments, and interest rates would result in a mortgage payment of $1,700. To do this, your best bet is to plug your information into this mortgage calculator.
Step 5. Reflect On What You Truly Need
After playing around with the calculator, you should have an idea of what kind of house you can afford in Denver.
Keep in mind, this number is based on a formula that doesn’t take all of your unique circumstances into consideration. Before deciding on how much to spend on a home, take a second to think about how much you actually need.
Remember—just because you can take out a million-dollar mortgage doesn’t mean you should.
Buying a house is one of the most important financial decisions of your life. It’s a decision that could affect you for decades to come and is not something to take lightly. That’s why it’s important to speak with a financial advisor to help you make a wise choice and avoid potential pitfalls. Here at Setchfield Asset Management, our financial advisors are trained to help you create a personalized “big picture” plan to help you achieve your financial goals—including your dream home and lifestyle. If you’d like to schedule an introductory meeting to see if we are the right fit, email me at firstname.lastname@example.org or call (303) 627-1099.
Steve Setchfield is Chief Investment Strategist at Setchfield Asset Management, an independent financial advisory firm. With almost 30 years of experience, Steve serves his clients by keeping them out of financial trouble in volatile markets, using a low-key, rules-based approach to investing and helping them with every aspect of their financial lives. Steve studied finance at the Metropolitan State University of Denver and spent several years working at Shearson Lehman Brothers and Kemper Securities before founding his own independent firm so he could offer objective, personalized advice and strategies. Steve is a Colorado native and enjoys skiing and other outdoor activities. He spends his free time volunteering for Big Brothers/Big Sisters of Colorado and coaching wrestling in the Cherry Creek school system. In 2003, Steve was a living kidney donor for his uncle who suffered from polycystic kidney disease. To learn more about Steve, connect with him on LinkedIn.