If you’re thinking about buying a new home, the question, “how much house can I afford?” is the first one to ask yourself. Many first-time home buyers need to ask this question, but may not. Determining the lending amount you can qualify for is the first official step you need to take. Some real estate agents and realtors require you have a mortgage pre-qualification letter before they’ll even agree to show you properties. The informal pre-qualification process gives you a general idea of the price range you can afford.
Even if it isn’t your first home, the most experienced home buyers may have questions about how much house they can afford. With constantly changing interest rates and criteria, it helps to stay up to date and fully understand what you can afford before getting that prequalification letter.
While there’s no universal formula for figuring out how much of a mortgage you can afford, there are some considerations and factors to keep in mind to help you get started.
What Affects How Much House You Can Afford?
Numerous factors influence the monthly mortgage amount you may be able to get approved for. One of the main influencing factors is your current annual household income. Of course, current debts also factor in as well. You may make a healthy annual salary of $100,000—but if your annual debt payments add up to $50,000 a year, that’s going to affect the loan amount a mortgage company is going to approve you for.
Debts that affect the amount of mortgage you qualify for include:
- Credit card debt
- Car payments
- Student loan payments
- Additional recurring debts
Your debts are looked at as your debt-to-income ratio. That ratio is you’re your amount of monthly debt payments divided by your gross monthly income. It’s a way lenders determine how risky or not it is to loan you money. For a mortgage, it’s thought that a 43%t debt-to-income is the highest ratio mortgage lenders will tolerate in a borrower. You can calculate your ratio with the Credit.com debt-to-income ratio (DTI) calculator.
Another important factor that mortgage lenders look at to determine your eligibility for a loan is your credit rating. Borrowers with less-than-ideal credit may have a harder time getting approved for certain types of mortgages and may end up with higher interest rates.
On the other hand, if you have a good credit score of 700 or above, you shouldn’t have any trouble getting approved for a competitive interest rate on your mortgage. See your credit score for free on Credit.com.
Prequalification versus Pre-Approval
When determining mortgage affordability, it’s important to understand the difference between your pre-qualification amount and the total amount you end up borrowing or are pre-approved for. Pre-approval is more official than prequalification. It’s a promise from the lender that you’re qualified to borrow up to a certain amount of money at a specific interest rate.
The amount you’re pre-approved for is the maximum amount you can borrow. That maximum is based on the information you’ve given the lender. It doesn’t necessarily mean that you should borrow that total qualifying amount for your new home.
Don’t Become “House Poor”
Say you get pre-approved for a $250,000 mortgage. You do the math and considering your monthly debt, utilities, home maintenance, homeowner’s insurance and other costs, and determine that you’ll be better off buying a home that costs no more than $175,000. While you could stretch your income to cover a $250,000 mortgage, it would be a stretch. And the last thing you want is to become “house poor,” where you’re left with little money after paying your mortgage each month.
When determining how much house you can afford, take your monthly costs and housing expenses into consideration. The steps below outline how you can determine your bills, compare that to your income and then use these figures to see you how much house you can afford without becoming house poor.
First, determine your take-home pay—or net monthly income. That’s your the total amount of money you bring home after all deductions including taxes, voluntary contributions and benefits. If you’re married, that may include both your income and our spouse’s income for a combined monthly total household income.
Then, take your net monthly income and multiply that number by 25%. The result is the maximum house payment you can afford.
For example if your net income is $3,000, 25% of $3,000 is $750. $750 is then the maximum mortgage payment you can afford.
If you’re unsure of the math, use a mortgage calculator to do the math for you. When determining your maximum monthly mortgage payment, you remember to deduct your down payment and consider the type of loan you want to get. A larger home value requires a larger down payment, and a 15-year mortgage means higher monthly payments than a 30-year fixed mortgage.
Don’t Forget Other Costs of Homeownership
When determining how much house you can afford, factor in the costs of home ownership. Putting in a yard, remodeling, unexpected repairs, upgrades and other fees can eat into your monthly budget and debt-to-income ratio. Be sure you have the money to cover these expenses while still being able to comfortably pay your mortgage payment every month.
Many mortgage lenders follow something known as the 28/36 rule for underwriting. A household should spend only 28% of its gross income on housing expenses. The 28% should also include the additional costs that come with owning the home like the homeowner’s association (HOA) fees, homeowners insurance and property taxes.
Types of Mortgages and Home Affordability
There are four main mortgage loans types available to home buyers.
- Conventional fixed-rate loans
- Adjustable-rate mortgage (ARM) loans
- Government-insured mortgage loans
- Jumbo mortgage loans.
A conventional fixed-rate mortgage is ideal for a primary home, second home or even investment property and the borrowing costs are often less than other mortgage types. With a fixed-rate mortgage, your interest rate is the same throughout the loan.
With an adjustable rate mortgage or ARM, which is also known as a variable rate mortgage, the interest rate can change after a specified period.
Fixed-rate loans tend to come with higher interest fees while adjustable rate mortgages offer homeowners the chance to save some money along the way. However, an ARM can cost you money too. The rate will change based on the current interest rate can you can end up paying a lower interest rate when the rate adjusts, but you can also end up paying a higher one.
Jumbo loans cost more and are much more common in higher-cost areas and often used for luxury properties. You’ll find they’re also much more difficult to qualify for, which makes them less common than other mortgage types.
Government-insured mortgages are backed by government agencies including the Federal Housing Administration, The U.S. Department of Agriculture and the U.S. Department of Veteran Affairs. These types of loans include FHA loans, VA loans and USDA loans.
Knowing which type of mortgage is best for you can help when you calculate how much house you can afford because it will give an idea of how much interest you might pay, how long of a loan term you’ll have and how much of a down payment you’ll need.
Additional Tips and Considerations
Another important consideration when determining how much house you can afford is your down payment. The down payment is the amount of money you put down on the house upfront and out-of-pocket. The minimum down payment on an FHA loan is 3.5% of the home’s total sale price. Other loans are available for no down payment. Conventional fixed-rate mortgages typically require a 20% down payment.
Some mortgage companies, require private mortgage insurance (PMI) for conventional loans on a home when you have less than 20% equity. So, if you can’t put down a 20% down payment, you may have to pay PMI, until you pay off 20% of the home value.
PMI protection the lender if you fail to make your monthly mortgage payments and default on the loan. If your mortgage comes with PMI, you should be able to stop PMI payments when your loan-to-value ratio reaches roughly 78% of your home’s value.
PMI can easily cost more than $100 per month-or $1,200+ per year. So, if you can, you may want to put down 20% or higher down payment on your new home to save money in the long term.
Many people can’t afford a 20% down payment on a home. If that is your situation, the best thing you can do to save money on your mortgage is to secure the lowest possible interest rate you can find. It may mean shopping around and submitting applications to a number of mortgage lenders.
With so many considerations to keep in mind when determining how much house you can afford, the process can seem a bit overwhelming. To help, try the Credit.com How Much House Can You Afford tool. It can help you get a better idea of how much of a mortgage you can comfortably afford based on your current annual income, monthly debt and other factors.
This article was last published January 13, 2017, and has since been updated by another author.