If you’re planning to buy a new home this year, this is NOT the time to buy a new car, unless you can pay cash, of course. While the mortgage industry has tightened up considerably since the recent recession, it appears the auto financing industry still subscribes to the fog-a-mirror standard in lending, that is, if you can fog a mirror, you qualify for a car loan. As a result, it is too easy for would-be homeowners to buy a new car while they may be house hunting.
Car payments often represent one of the largest liabilities of a borrower. The new monthly payment significantly increases their debt-to-income ratio (DTI). DTI is an important factor in qualifying a borrower for a loan. If DTI is excessive, it can disqualify a borrower.
There are two types of DTI, the non-mortgage liabilities, referred to as front-end DTI, and total liabilities (non-mortgage obligations plus housing expense), referred to as back-end DTI. Front-end DTI consists of liabilities such as credit cards and lines of credit (revolving accounts) and installment accounts, such as car loans. Housing expense includes the principal and interest portion of the mortgage payment, in addition to real estate taxes, hazard insurance, mortgage insurance, and HOA dues.
While many loan products consider only the back-end DTI, some also have maximums on the front-end. Exceeding either the front-end or back-end DTI could disqualify the borrower for the loan amount they need. Although there are exceptions, 43% as a maximum total DTI is a good rule-of-thumb. So, let me give you an example of how adding a monthly car payment affects your borrowing power:
Assume a borrower has monthly gross income of $3,000. Her total debt, including the proposed mortgage, should not exceed $1,290 ($3,000 x .43). Her non-mortgage debt amounts to $350, consisting of a car payment of $275, and balance of $75 in credit card payments. That means, she would qualify for a total mortgage payment of $940 ($1,290 – $350).
That $940 must include principal and interest (PI), real estate taxes, and home insurance, plus any mortgage insurance (MI) and HOA dues. If we assume no MI or HOA fees and estimated real estate taxes and home insurance are $150/month, that means the mortgage PI payment cannot exceed $790 ($940 – $150). A monthly payment of $790 on a 30-year fixed-rate conventional loan at 4.5% interest results in a loan amount of $155,915, for which she would qualify.
Now, let’s assume the same as the latter case, but this borrower does not have a car payment of $275. In this case, her PI payment could be as much as $1,065 ($1090 – $75 – $150). And that qualifies her for a loan amount of $210,190. That is a difference $54,280 in the amount of the loan for which she would qualify. That $275 car payment reduces her home buying power by over $50,000! And the kicker? In all likelihood, she would still be able to buy that new car worth about $15,000 after she bought her new home.
The moral of the story—buy the house before the car!!