As you work toward the goal of buying a new home, you'll likely find that you can reach the finish line a little easier if you first decide how much house you can afford. Although you may have a guesstimate of an affordable monthly mortgage payment, this amount actually represents more than just coming up with an arbitrary figure that "sounds right" or "feels comfortable." There are numerous pieces to the mortgage qualifying puzzle, all of which work together to make affordable homeownership a reality and leave you with monthly debt payments that are manageable.
So, before making an appointment with your lender to apply for a mortgage after seeing a "for sale" sign in the yard of that cute Cape Cod with the picket fence, perform a few calculations. This way, you can discover some of the same numbers that mortgage lenders calculate when approving loans for real estate. You can use your own calculator, or even easier, you can plug your numbers into some of the reputable online mortgage calculators and let them do the math for you.
The actual dollar amount of a house you can afford depends on numerous factors, including the amount of debt you have compared to your income, your credit score, the amount of your down payment and other lender-specific underwriting requirements.
Calculating Debt-to-Income Ratio
One important consideration that turns potential homebuyers into first-time homeowners is their debt-to-income ratio, or DTI. This calculation helps mortgage lenders determine the amount of mortgage debt that an applicant can handle based on the applicant's monthly income and debt payments. Calculate your DTI by dividing your total monthly debts by your gross monthly income (the amount of money you make before taxes) and multiplying by 100 to express the result as a percentage.
Examples of monthly debts are mortgage/rent payments, credit card payments, student loans and car payments. Child support and alimony payments are also included when calculating your DTI. Other monthly expenses that you do not include when calculating DTI are utility bills, grocery costs, car insurance premiums and health insurance. These costs are not classified as true debts, simply expenses.
For example, if your gross monthly income is $6,000 and your monthly debt payments total $2,100, your DTI is 35 percent ($2,100 debt divided by $6,000 x 100). A DTI of 36 percent (or lower) falls in the sweet spot that most mortgage lenders like to see. Some lenders, depending on the type of mortgage, approve mortgages up to 45 percent DTI, and some Federal Housing Administration (FHA) loans allow a DTI of 50 percent. If your DTI is 36 percent or lower, however, you'll have more flexibility in qualifying for different types of mortgages.
By using an online debt-to-income calculator, all you have to do is enter your income and debt information in the fields provided, and the calculator automatically calculates your DTI. If your DTI is too high to qualify for a mortgage, you can enter different figures in the fields to find out how much you'll have to increase your income or reduce certain debts to lower your DTI within an acceptable threshold.
Using the 28 Percent/36 Percent Rule
To see through the eyes of mortgage lenders and determine how much monthly mortgage debt you can handle, calculate the two different types of DTI: front-end DTI and back-end DTI. This is also referred to as the 28 percent/36 percent rule. Front-end DTI considers the part of your debt that includes only housing costs, including mortgage payments, homeowners' insurance and property taxes. This calculation should be 28 percent or less. Back-end DTI considers all your monthly debt payments (including credit cards, student loans, etc.); this should be 36 percent or less.
To calculate the maximum monthly mortgage payment that your income and debt load can handle, multiply the same gross monthly income ($6,000 in this example) by 28 (6,000 x 28 = 168,000) and divide by 100 to reveal a maximum monthly mortgage payment of $1,680. This payment includes mortgage principal, interest, property taxes and homeowners' insurance plus homeowners' association (HOA) fees if applicable.
The Importance of Credit Scores
Another mortgage affordability factor is your credit score, which gives lenders an overview of your financial health. These scores, which range from 300 to 850, are grouped into tiers. Tier one represents the best credit rating, tier two is the next-best rating and so on. Different lenders use different calculations to determine which borrowers fall under each tier, so the same borrower may fall under tier one with one lender but under tier two with another lender.
Using the FICO scoring model, a credit score of 800 to 850 is considered the best rating (tier one), but some lenders may consider tier one to include credit scores of 750 to 850. When applying for a mortgage, it often pays to shop different lenders to get the best interest rate because mortgage rates depend in part on credit scores. As a rule of thumb, the higher the credit score, the lower the interest rate (and therefore, a lower monthly payment).
Down Payment Impacts Home Affordability
You can only afford to buy a house if you can also afford the down payment. In an ideal world, all homebuyers would be able to afford to pay 20 percent of the purchase price as a down payment, and your lender would finance the 80 percent balance as a mortgage. However, most Americans (around 76 percent according to the National Association of Realtors) put down less than 20 percent for a down payment. Most lenders will likely approve a mortgage with less than a 20 percent down payment, but you'll have to tack on private mortgage insurance (PMI) to your payments. PMI is an insurance policy that protects lenders from loss when a borrower defaults.
Don't have 20 percent of a listing price on hand in cash? You have plenty of other options. Notably, some conventional loans only require a 3 to 5 percent down payment, and FHA loans require a 3.5 percent down payment. Regardless of the type(s) of mortgage for which you qualify, a higher-than-required down payment can lower your monthly payments and/or reduce the loan term, so ideally you'll put down as much as you can. Consult with your lender, however, to determine whether allocating your assets is better served over the life of the loan by making a bigger down payment, paying the closing costs in cash (instead of rolling them into the mortgage) or other financing considerations.
Home Affordability Calculators
Using a home affordability calculator doesn't guarantee mortgage loan approval, but it can be a useful tool to help you determine how much house you can afford. Instead of learning how to put all the puzzle pieces together by using manual calculations, such as DTI, credit score and down payment, simply enter the information as prompted by each field of the calculator. After the calculator processes the data, it displays the price of a home, which should fit your income and debt load.
Other than your income and debts, you'll also need to know the amount of property taxes and homeowners' insurance (including PMI if needed) that you'll have to pay, both of which must be included in total housing debt as line items in the home affordability calculator. An online search or a call to your local tax office reveals how much property tax is assessed for the address of your potential new home. Contact insurance companies to find out how much you'll pay for homeowners' insurance. If the property you're considering is governed by an HOA, you'll need to enter the amount of HOA dues.
Lastly, don't overlook the importance of having a little wiggle room when determining how much house you can afford. Maintenance and repair costs are part of the responsibilities of homeownership. Consider the industry recommendation of having 1 to 3 percent of the value of your home set aside in an emergency repair fund. This way, if your air conditioner conks out during the hottest month in summer (think Murphy's Law), you'll have the funds on hand for a quick replacement.
Victoria Lee Blackstone is a horticulturist and a professional writer who has authored research-based scientific/technical papers, horticultural articles, and magazine and newspaper columns. Her writing expertise covers diverse industries, including horticulture, home maintenance and DIY projects, banking, finance, law and tax. Blackstone has written more than 2,000 published works for newspapers, magazines, online publications and individual clients.