Get ahead of the house-hunting game by determining how much home you can afford
Your housing expense ratio and debt-to-income ratio are major factors for calculating how much house you can afford.
Lenders often use the 28/36 rule to determine a manageable mortgage payment.
It’s recommended that you set a housing budget before researching or touring homes.
Are you wondering if it’s the right time to buy a house? Whether you’re preparing to purchase your first home or buy an investment property, the first step is to evaluate your financial situation and determine how much home you can afford.
Luckily, there are several ways to calculate how much mortgage you can afford based on your current debt, income, and expenses. Read on to learn what goes into determining how much you can spend on a new home.
Looking for a new home is an exciting process—it’s fun to scroll through photos of homes in your desired area and daydream about moving in. But it’s essential to house hunt with a strict budget in mind to avoid purchasing a house that’s more expensive that you can afford.
Before creating your house-hunting checklist, calculate your maximum budget for your monthly mortgage payment, down payment, and home price. This crucial step will help you set a realistic price range for your future home and stay on track during the home-buying process.
If curiosity takes over, you can drop your current financial information into a home affordability calculator to get an estimation of how much house you can afford before applying for a home loan.
For example, this home affordability calculator from Freddie Mac provides a payment breakdown of your total monthly payments and ideal home worth based on your financial details and mortgage requirements.
There are multiple ways mortgage lenders calculate how much house you can afford, but your housing expense ratio and debt-to-income ratio are two of the main factors. These calculation methods predict whether or not you can pay your mortgage payment each month.
The housing expense ratio (also known as the house-to-income ratio and the front-end ratio) is the percentage of your income dedicated to your housing costs, including mortgage payments, taxes, and homeowners insurance. Mortgage lenders use this ratio as one way to determine how much money to loan you for your mortgage. Many mortgage professionals advise that you should spend a maximum of 28% of your gross income (before taxes and deductions) on housing.
Here’s how to calculate your housing expense ratio:
Add your total housing expenses, including monthly mortgage payment (principal, interest, taxes, and insurance).
Divide that number by your pre-tax income.
Convert that number into a percentage by multiplying by 100.
If your housing expense ratio exceeds 28%, you’re likely overextending yourself financially under those circumstances.
When reviewing your mortgage application, mortgage lenders also take your debt-to-income ratio (DTI) into account. This ratio is expressed as a percentage, and it represents your monthly debt payments divided by your monthly gross income. A low debt-to-income ratio helps you qualify for a favorable mortgage rate because lenders trust your ability to pay the loan each month.
Here’s how to calculate your debt-to-income ratio:
Add your monthly debts (except taxes, utilities, and groceries), such as rent or mortgage payments, credit card payments, car loans, student loans, alimony, and child support.
Second, divide all your debts by your gross monthly income. The percentage remaining is your debt to income ratio.
When you apply for a mortgage, many lenders use the 28/36 rule to ensure you can afford the loan and its monthly payments. Mortgage lenders like to see that you spend no more than 28% of your gross monthly income (your housing expense ratio) on housing expenses and 36% of your income on your total debts (debt-to-income ratio). Each bank and lender calculates borrowers’ risk differently, so you may also see the 29/41 rule, but the concept is the same.
Mortgage lenders want to ensure you're financially prepared to take on new debt, so they’ll also look at your overall financial status. As a future homeowner, you’ll need to know how other financial factors contribute to how much house you can manage.
Your credit score is a significant factor on the path to a home loan. Before applying for a mortgage, check out your credit report and correct any mistakes. Lenders usually consider credit scores above 720 excellent, but you can qualify for loans with a lower credit score. However, a low credit score may affect your mortgage rate.
Buying a home is more than a monthly mortgage payment, which is why your lender wants to ensure you have enough cash for other costs associated with buying a home, including closing costs, property taxes, private mortgage insurance, and homeowners insurance. Lenders also want proof that you have adequate savings in your emergency fund in case of job loss or financial change.
You can provide your savings and investment account balances during the loan application process to prove you’re financially ready to buy a home. For example, if you receive passive income from an investment rental property, you should list this additional funding to prove you can afford a new mortgage.
Your mortgage term is the amount of time it takes to repay your home loan. Most borrowers choose a 15 or 30-year loan, but some banks offer different terms. If you choose a shorter term, your monthly mortgage payment is higher, but you’ll own your home faster. Longer mortgage terms have lower monthly payments, but the payments stretch for years ahead.
Your mortgage rate is the interest rate attached to your loan. It also affects your monthly mortgage payment amount. The higher the interest rate, the more your monthly payment increases. Your lender will consider factors like your credit score and down payment amount and then, according to your information, offer you a fixed or adjustable-rate interest rate. Talk with a local mortgage broker to find the best combination of mortgage terms and mortgage rates for your finances.
A down payment is the percentage of the home’s purchase price that you pay upfront. Traditionally, a down payment is 20% of the sale price, but some loans require far less or even no down payment. Keep in mind that the larger the down payment, the smaller the monthly payment amount. Your mortgage application also looks more attractive to lenders if you secure the purchase with a significant down payment.
Along with determining your home-buying budget, you should learn about the types of home loans available, especially if you're a first-time home buyer. Home loans aren’t one size fits all, so talk with multiple mortgage professionals before deciding which loan makes the most sense for you.
Conventional loans are the most popular type of home loan, and it requires stricter debt-to-income ratio and credit score requirements. To qualify for a conventional mortgage, you’ll need a minimum credit score of 620, plus the ability to put down at least a 3%down payment. This loan type can be conforming or non-confirming, and it’s ideal for a borrower who has a low debt-to-income ratio and a strong credit score.
The name proceeds this type of loan. A fixed-rate loan carries the same principal and interest rate through the mortgage term, which is typically 15 or 30 years. This type of loan is popular with homeowners who want to pay the same mortgage payment for the life of the loan. However, interest rates are typically higher for fixed-rate mortgages than adjustable-rate loans.
Adjustable-rate mortgages (ARM) have fluctuating interest rates that depend on current market rates. Most loan holders get a fixed-rate period at the beginning of their mortgage term, then it changes based on market conditions. ARM loans typically allow homeowners to save on interest payments over time, they risk having to pay higher rates over time.
The U.S. government partially insures certain loans through the Federal Housing Administration (FHA), the U.S. Department of Agriculture (USDA), or the U.S. Department of Veterans Affairs (VA). There are specific qualifications for each loan type, so be sure to research whether you can consider applying for government-backed loans. A government-backed loan could be a good choice if you’re a first-time home buyer with less than a 20% down payment, served in the military, or buying a home in a rural area.
