Knowing how much mortgage you can afford depends on several important factors. These factors, taken together, create your total affordability picture. The rule of thumb is that lenders look for the three primary factors when deciding how much mortgage a homebuyer will qualify for:
- Your annual household income
- Your credit score(s), which includes FICO
- The total down payment (as a percentage of total home value)
In a best-case scenario, lenders love to see buyers with a high income, high credit score, and high down payment. But in the real world, we all know how difficult this is to achieve. Thus, do not fret! Learning how mortgages work and which factors are important by lenders are described below.
Your Income
Your income is the driving factor in how much home you can afford. The rule of thumb is you should not spend more than 28 percent of your monthly income on a mortgage and more than 36 percent on total debt overall. This 28/36 rule is often referred to as the debt to income ratio and is a deciding factor on how much lenders are willing to loan you for the purchase.
In general, keeping your mortgage payment low as compared to your income helps you avoid some of the common mortgage mistakes many first-time homebuyers make. First, it keeps you from stretching the budget to make your mortgage payment. Lenders like to see a cushion of cash between your debts and your expenses to ensure that you can pay the mortgage should you lose your income. The lender is taking a risk in loaning you the money for the mortgage, so a lowered payment for you mitigates their risk and makes it more likely that you will be able to repay it.
Secondly, a low debt-to-income ratio suggests that you are responsible with your personal finances and can handle and repay credit. If you have maxed out credit cards, high loans, and income that barely covers your debts, lenders may be reluctant to loan you the cash or grant you a loan with the best terms.
Your Credit Score
Knowing your credit score to buy a home is one of the first steps you’ll want to take. If you have a high credit score, you may qualify for some of the best rates when it comes to getting a mortgage. You may also be eligible for higher-priced mortgages that give you the option to own a better home in a more expensive housing market. Again, it pays to lock-in a mortgage rate and keep your mortgage affordable, even if the lender is willing to loan you more than you expect for your budget. If you have less than perfect credit, your lender may offer you a smaller loan with a higher interest rate. The higher the score, the less interest you pay overall. The difference between the cost of a home for a well-qualified buyer and one with damaged credit can add up to tens of thousands of dollars over the life of the loan.
Typical lenders desire clients with credit scores higher than 650 points, while government-backed lenders can offer loans to individuals with scores below 600. There are options for homebuyers who want to get a loan with bad credit, specifically around FHA loans and other government-backed programs. Organizations and websites, such as the VantageScore and FICO, contain the credit score necessary for affordability calculation. Furthermore, one can access their credit reports by visiting the annual credit report, TransUnion, Equifax, and Experian websites.
Your Down Payment
Traditional conventional lenders often ask for a down payment of 20 percent in order to lend you the cash you need for your home. On a $200,000 home, this is about $40,000. This amount is only for the down payment and doesn’t factor in closing costs, adding up to several thousand more.
There are, however, programs for buyers that allow you to get a mortgage with as little as three percent down. In some states, you can even get a loan to cover the amount of the down payment. The problem, however, with the small down payments is that they often represent a budget stretch. The smaller the down payment, the larger the mortgage payment, and the more interest you will pay over time.
The Annual Salary Rule: Know your “qualification ratios”
In order to prevent a lender from defaulting on a hard money loan, financial planners have a simple rule for determining whether your income is sufficient for your home purchase. The ideal mortgage amount (and associated costs) should never exceed three times your annual salary. The “associated costs” include insurance, interest, and taxes (along with the principal, the acronym for these costs is PITI). This means that if you are earning $50,000 a year, your mortgage should not be more than $150k. If you are preparing to buy a home with your spouse and have a combined income of $100,000, then you have a bit more room to pay more, with a mortgage amount of $300,000.
More specifically, there are a handful of qualifying ratios banks use to determine if you qualify for a mortgage. Each lender is different, and each borrower is different, so take these with a grain of salt (i.e., they may differ for you and your specific needs). That said, you can use them as a rule of thumb when determining how much mortgage you can qualify for.
Front-end ratio: PITI ratio
The front-end ratio, otherwise identified as the mortgage-to-income proportion, defines the percentage of an individual’s annual gross income allocated to service monthly mortgage payments. Principal, interest, taxes, and insurance (PITI) make up the monthly installments expected to service the loan. The rule of thumb here is that prospective homebuyers should keep this ratio below 28%.
Back-end ratio: Debt-to-income ratio (DTI)
Lenders like to look at how much debt you have as compared to your annual gross household income. This ratio is known as your debt-to-income ratio (DTI), or backend-ratio for short. The rule of thumb is that after you secure your mortgage loan, your DTI should not exceed 33-36% for conventional or jumbo loans and no more than 29% for FHA loans. Keep in mind this ratio is calculated after you consider your mortgage debt, including PITI! Therefore, a lower DTI ratio significantly improves your mortgage affordability.
The gross income is your household salary (you and your spouse), combined with any bonus earnings, alimony, disability, and self-employment proceeds.
Household debts include child support, student loans, and credit card expenses.
The Home’s Condition
Another consideration that is often overlooked is the home’s condition for determining how much you will need for your purchase. If your house needs expensive repairs to make it suitable for moving in, you will need to factor this in when figuring out how much mortgage you can afford. Here’s an easy example:
Brenda and Mark want to buy a fixer-upper in an up and coming neighborhood. The house they want to buy is a steal at $110,000, but it will need about an additional $70,000 in repairs to make it livable. Brenda and Mark plan to make a down payment of $22,000, 20 percent of the home’s purchase price.
Since Brenda and Mark will ultimately need about $180,000 ($110k + $70k) for their home purchase, lenders will decide whether Brenda and Mark have the credit, cash reserve, and income for a $180,000 purchase rather than a $110,000 purchase.
In addition, while their $22,000 down payment represents 20 percent of their investment on the $110,000 home, it represents less than 20 percent on the renovated home. Therefore Brenda and Mark may not qualify for the most favorable rates they would have gotten with the 20 percent down payment.
Lenders typically require you to order a professional home inspection before they approve the loan, so keep this in mind when planning your mortgage budget (note there are different types of home inspections). If the home inspection reveals additional issues that must be repaired, it can lower the home’s overall value, reducing the amount that the lender is willing to lend. So while you may have a pre-approval for $200,000, a home that needs a $10,000 roof replacement ultimately means that the bank may decide that the house is only worth $190,000. This means that your down payment may fall below the 20 percent mark. Consider doing a your own personal home inspection before spending money on a professional.
Additional Expenses to account for
When creating your budget, there are a handful of other expenses you will need to budget for, beyond just the mortgage costs. These include:
- Maintenance costs. Who will manage the garden? Who will mow the lawn? Or what about the new exterior paint job you wanted? These maintenance costs add up over time so be careful.
- Utility costs. Depending where you lie, this could include water, gas, electric, trash, recycling, etc. The list goes on.
- Insurance. As discussed above, there’s a few different insurances. These include homeowners insurance, PMI, and maybe even full-replacement insurance.
These are just a few of the monthly costs associated with owning a home.
Make Yourself Attractive to Lenders
If you want the best chance at getting a competitive loan with favorable terms, create a profile of yourself that makes you look great to lenders. We hope this article covered all the basic mortgage questions you may have, but if not, here is a quick review:
A good credit score with a long history of paying on time for other loans is the foundation. A steady and high paying job, preferably with the same company, also makes you look great to lenders.
Have you gotten consistent income over time? Do you have evidence of favorable evaluations on your job or promises of future promotions? Is your career field stable or growing? Do you have additional sources of income like a small side business, rental income, or inheritance? Creating this profile can help you get approval for a higher loan amount if the lender is on the fence.
A healthy savings account with about six months of mortgage payments also makes you look like a great candidate to the lender. Zero or low debt also looks excellent on paper and lets lenders know that you are low risk. While most people will have some debt obligation, a history of responsible debt repayment will help you shine when it comes to getting favorable terms.
Finally, the ideal borrower has a financially responsible partner. Who you are partnered with goes a long way in determining what type and how much of a mortgage you can get. Suppose your partner has the same history of on-time payments, high income, and steady employment. In that case, you will be viewed as the right candidate for a mortgage and have multiple lenders competing for your business, offering you only the best rates for your new home purchase.
When thinking about how much mortgage you can afford, consider all of the factors that your lender will consider and start shopping for your dream home today.