Whether you’re buying your first home or upgrading to suit your current needs, the first step in the process for many buyers is determining their purchase limit and what financing they can qualify for.
Part of this calculation depends on evaluating your personal finances and developing a budget to support your plan to purchase a new home. Then, you’ll want to see how much of a mortgage payment you can realistically afford and qualify for, given your lender’s requirements.
We have resources to support you with the budgeting aspect, and, in this post, we will break down how to estimate your mortgage affordability.
How Do I Calculate How Much Home I Can Afford?
There are a couple of different ways to approach calculating the range you should aim to keep your purchase in.
Annual Gross Income
Some financial advisors will suggest setting a range based on two to two-and-a-half times your annual gross income. With this strategy, a family earning a combined household income of $250,000 a year should aim to purchase a home costing $500,000 to $625,000.
Debt-to-Income Ratio
While that approach can help you quickly generate some rough estimates, it’s important to note that many lenders base their loan approvals on the applicant’s debt-to-income ratio. Your DTI ratio is calculated by taking your total monthly bills and dividing that by your total gross monthly income.
Using the same annual income as our previous example ($250,000 annually, which is $20,833.33 monthly), and estimating their total monthly debts (including housing expenses) at $8,000, we could calculate their DTI ratio.* We would take their monthly debts of $8,000, and divide that by their monthly income of $20,833.33, equaling a ratio of 38.4%. As a general rule of thumb, you should aim to keep your DTI ratio at 43% or less, and in this example the family would come in under that threshold.
Similarly, they could work backwards, multiplying 43% times their monthly income of $20,833.33 to establish a total monthly debt maximum of $8,958.33 for their budgeting purposes.
Getting Pre-Qualified or Pre-Approved
While initial calculations based on your annual gross income or debt-to-income ratio can help set you on the right path, the best way to get an accurate handle on how much you can afford is by getting pre-qualified or pre-approved.
Typically, a pre-qualification will come before being pre-approved. To pre-qualify with a lender, you’ll provide them with an overview of your finances. There is typically no credit check involved, and after review, they’ll be able provide you with an estimate of what you may qualify for.
Taking it a step further, you can get pre-approved. For this, you’ll complete a loan application. The lender will review income, debts, expenses, credit history, and other information to verify your eligibility for a mortgage. If you qualify, your lender will provide a pre-approval letter, which becomes a valuable resource in your search for a home.
How Does My Credit Score Impact My Mortgage Affordability?
Your credit score is a measure of your likelihood of repaying your loan on-time and in full. When lenders evaluate your loan application and work to determine what programs you qualify for, part of the evaluation involves your credit score.
If you have a higher credit score, you can generally expect to qualify for better interest rates, which impacts your monthly mortgage payment amount. Your credit history may also factor in to the loan-to-value (LTV) ratio that you can qualify for, which determines how much you can finance compared to overall value of your home. Credit scores can even impact the rate you’ll be charged for private mortgage insurance.
Revisiting our first section on pinning down your price range, you’ll now see a clear correlation between your credit score and how much house you can afford to buy.
How Does My Down Payment Affect How Much House I Can Afford?
Aside from your DTI ratio and credit score, which relate to the ongoing affordability of your mortgage, you also can’t neglect the importance of your down payment and closing costs.
Your down payment will depend largely on the loan program you’re financing with. You might think you still need 20% saved up to put towards your down payment, but there are many options available that require much less. If you obtain an FHA loan, for example, your down payment could be as low as 3.5%. Similarly, if you qualify for a VA loan or USDA loan, you could close with no money down, relieving you of the concern of planning for a down payment altogether.
For your planning purposes, though, you should anticipate being able to pay your down payment and still have three months of your total monthly debt payments set aside as general financial advice.
Closing costs are a little more straightforward to prepare for. As a rule of thumb, the average closing costs run between 2 to 5 percent of your loan amount.
Plan For Homeownership Expenses Beyond Your Mortgage Payment
While your monthly bills and your mortgage payment play significant roles in determining the affordability of your home purchase, there will also be standard and even unexpected expenses that come along with homeownership. Don’t let yourself get caught off guard and add unnecessary stress to your personal finances.
Be sure to factor in maintenance, utilities, and potential upgrades to appliances or home furnishings to give you and your family breathing room to enjoy your new home without the need for financial concerns. A general guideline is to set aside 1 to 4 percent of the value of your home for upkeep expenses.
Putting It All Together
As you gear up for your next home purchase, spend some time determining what you’re likely to be able to afford utilizing the DTI ratio method. Make sure to review your credit score to be prepared for what rates your lender will be able to offer. Then take a look at what your down payment and closings costs will be while leaving room in your budget and savings for unexpected homeownership-related expenses. Finally, you’ll be able to solidify your estimates by getting pre-qualified or pre-approved.
Request a consultation with our team today to determine your home financing options and budget. They will be glad to help you start the process through pre-qualification and pre-approval.
The included content is intended for informational purposes only and should not be relied upon as professional advice. Additional terms and conditions apply. Not all applicants will qualify. Consult with a finance professional for tax advice or a mortgage professional to address your mortgage questions or concerns. This is an advertisement. Prepared 8/12/2021.
*In this example, the following loan scenario based on a $500,000 purchase price was utilized:
A 30-year fixed rate mortgage loan in the amount of $400,000, a down payment of 20%, an APR of 3%, an estimated annual homeowner’s insurance premium of $750, estimated annual property taxes of $5,500, and no private mortgage insurance, resulting in a total monthly mortgage payment of $2,628.85.