*As of July 6, 2020, Quicken Loans is no longer accepting USDA loan applications.
The amount of home you can afford directly relates to how much mortgage you can qualify for and how much debt a lender thinks you can take on.
We’ll go into the details of this process to help you determine how much house you can afford and what this means for you as you search for your dream home.
The 29/41 Rule Of Thumb Of Home Affordability
When lenders evaluate your mortgage application, they calculate your debt-to-income ratio, which is your monthly debt payments divided by your monthly gross income. Lenders look at this number to see how much additional debt you can take on.
According to the 29/41 rule of thumb, in order to get approved for a mortgage, it’s best to keep your DTI within a range that’s defined by these two numbers. Here’s an example.
The first number, 29, represents your housing expense ratio. This is calculated by dividing your mortgage payment (principal, interest, real estate taxes, homeowners insurance and if applicable, homeowners association dues and mortgage insurance) into your gross monthly income and converting to a percentage. It’s defined by the following formula:
The 41 represents your total DTI after all your other debts are added, including revolving debt (credit cards and other lines of credit) and installment debt – mortgage, car payment, student loans, etc. That equation follows:
The 29/41 rule is important to know when thinking about your mortgage qualification because DTI is one of the key factors that lenders look at when determining your ability to make the grade for any mortgage option. Although higher housing expense and DTI ratios are allowed under many loan types (including conventional, FHA, USDA and VA loans), this rule provides a good starting point.
To calculate how much house you can afford while maintaining a wide range of loan options, make sure your mortgage payment (principal, interest, taxes, insurance and homeowners association dues) is no more than 29% of your gross monthly income, and your total monthly debt (mortgage plus car loans, student debts, etc.) is no more than 41% of your total monthly income.
How To Calculate DTI
Mortgage lenders consider DTI an important qualifying factor because the amount of debt you have is considered a very reliable predictor of the risk associated with the approval of any mortgage loan. Therefore, it’s important to know your numbers. Let’s look at how DTI is calculated.
Step 1: Add Up All Of Your Monthly Debts
Your debt payments could include:
- Monthly rent or house payments
- Monthly child support payments or alimony
- Student loan payments
- Car payments
- Monthly credit card minimum payments
- Any other debts you might have
You don’t need to add in:
- Grocery bills
- Utility bills
- Any other bills that may vary month to month
Step 2: Divide Your Monthly Debts By Your Monthly Gross Income
Next, do a simple calculation. For example, let’s say your debts add up to $2,000 per month. If your monthly gross income (your before-tax income) is $6,000 per month, then your DTI ratio is 0.33, or 33%.
Home Affordability: Factors To Consider
Although DTI and housing expense ratio are very important factors in mortgage qualification, there are other things that impact both your monthly mortgage payment and the overall picture of how much you can afford. What follows are several factors to keep in mind before you hit the pavement looking for a new home.
Mortgage term refers to the length of time you have to pay back the amount you’ve borrowed. The most common loan terms are 15 and 30 years, though there are other terms available.
Mortgage term impacts your monthly payments. Here’s an example:
If you buy a $200,000 house with a 15-year fixed rate mortgage at 3.90%, your monthly payments are $1,469.37 (excluding taxes and insurance).
Now, let’s change the term. Let’s say you still buy the $200,000 house at 3.90%, but the term is 30 years. Your monthly payments are $943.34 (excluding taxes and insurance).
Once you close on your home loan, your monthly mortgage payment may well be the biggest debt payment you make each month, so it’s important to make sure you can afford it. Along with the down payment, this is probably in the top two biggest factors of how much you can afford.
Mortgage Interest Rate
Mortgage rate refers to the interest rate on your mortgage. Mortgage rates are determined by your lender and can be fixed or adjustable (aka variable), which means that they can stay the same or change over the life of the loan. Your rate can vary depending on your credit score, down payment and other factors.
Say you bought the same $200,000 house as above with the 15-year fixed mortgage at 3.90%, but we changed the mortgage interest rate to 4.25% instead. Your payment would go up from $1,469.37 to $1,504.56 per month.
You want the lowest interest rate possible because when you’re taking a loan for hundreds of thousands of dollars, even a small difference in interest rates could mean hundreds or even thousands of dollars difference in interest paid over the life of the loan. Interest rates also affect your overall monthly payment, which has the biggest direct impact on affordability.
Your Savings And Investments
Now that you’ve looked at your DTI and any debt, think about your budget. How does a mortgage payment fit in? If you don’t have a budget, keep track of your income and expenses for a couple of months. You can create a personal budget spreadsheet or use any number of budgeting apps or online budgeting tools.
In the mortgage process, it’s important to look at your budget and savings for a couple of reasons. One, you might need savings for a down payment, which we’ll discuss in a later section. However, for now, let’s go over something called reserves. These may be required, depending on the type of loan you’re getting.
Reserves refer to the number of months of mortgage payments you could make out of your savings if you lost your job or had another event that impacted your ability to make your payment. Every loan program is different, but a good general guideline is to keep at least 2 months’ worth of mortgage payments in your savings account.
Take a look at your full financial picture after you’ve tracked your income and expenses for a few months. For example, if you realize you have $3,000 left over at the end of each month, decide how much of that could be allocated toward a mortgage. Alternatively, you could buy a slightly more affordable house, and take some of your extra money and put it toward your mortgage principal every month in order to pay off the loan faster.
You might think you need to plunk down 20% of your purchase price for a down payment, but that’s actually not true. You can get a conventional loan (a loan (not backed by the government) for as low as 3% down.
That’s not to say there aren’t advantages to a higher down payment. For starters, interest rates are decided primarily based on two factors: down payment and median FICO® Score. The higher your down payment is, the better your interest rate will be. If a lender doesn’t have to loan as much money, the investment is considered a better risk.
It’s also true that you’re considered a bigger risk to a lender if you put less than 20% down for a conventional loan. If you do put down less than 20%, you’ll pay something called mortgage insurance, which can involve a monthly fee as well as an upfront fee depending on the loan option you qualify for.
Mortgage insurance protects your lender and the mortgage investor if you don’t make payments and default on your loan. As you determine how much house you can afford, remember to factor in down payments, especially if you’re trying to afford the 20% to avoid PMI.
Note that you might not have to put down anything at all if you qualify for certain government loans.
In addition to the cost of your down payment and any private mortgage insurance, you’ll also need to consider homeowners insurance, taxes and closing costs:
- Your homeowners insurance amount depends on where you live, your neighborhood and the type of home you buy. Homeowners insurance calculations also consider the value of your property, potential rebuild costs and the value of your at-risk assets. It’s best to call an insurance agent to get an idea of what your homeowners insurance amount could be.
- If you own property, you pay property taxes, which amount to your property’s assessed value multiplied by the local tax rate. You can ask your local tax assessor for more information.
Closing costs must be paid during closing, the last step in the home buying process. Your lender will give you an estimate of your closing costs. These usually include the loan origination fee, appraisal fees, title search fees, credit report charges and more. Typical closing costs on a home purchase can be anywhere from 3% – 6%.
3 Tips For Buying An Affordable Home
Suppose you qualify for a large home loan. Does that mean you need to borrow the entire amount your lender is willing to loan you? Of course not.
Assessing how much mortgage you can handle requires a bit of a look into your current and predicted future financial situation. Before you take on the maximum loan you can get and start looking at more expensive houses, consider these tips.
Be Conscious Of Changes In Employment
If you lose your job, how will you pay your mortgage? When you apply for a mortgage, your lender ideally will want to see a 2-year work history before they grant approval. If you choose to take the largest loan you qualify for, will you be able to make those higher monthly payments during a period of unemployment?
Understand The Different Types Of Mortgages
- VA Loan: A VA loan is a mortgage option available to United States veterans, service members and their (usually) non-remarried spouses. They’re offered by traditional lenders and backed by the U.S. Department of Veteran Affairs. VA loans are no-down-payment loans that offer more lenient credit and income requirements. Quicken Loans® requires a 620 median credit score.
- FHA Loan: An FHA loan is a loan that is backed by the Federal Housing Administration. If you have a lower credit score and less money for a down payment, you might qualify for an FHA loan. To qualify through Quicken Loans, you’ll need a 580 median credit score and a 3.5% down payment.
- USDA Loan: A USDA loan is backed by the U.S. Department of Agriculture. You could be eligible for a USDA loan if you want property in a qualifying rural or suburban area and if you’re a low-to-moderate income earner. You can get a USDA loan with no down payment. You’ll also need a 640 median FICO® Score at Quicken Loans.
All three government-backed loans have mortgage limits, which is a handy way to help you stay in a healthy debt-budget range.
Plan For Emergencies
Emergencies strike when you least expect them – emergency medical treatments, a flooded basement, a car on the fritz. Putting all your extra funds toward mortgage payments instead of saving for a rainy day can spell disaster.
Having an emergency fund can be a good safety net for emergencies and job loss. A good rule of thumb is to sock away 3 – 6 months’ worth of expenses. Your emergency money can go toward paying your mortgage if need be.
Summary: Deciding How Much House You Can Afford
Ultimately, how much home you can afford depends on your financial situation and preferences. It requires a more comprehensive decision than just how much money you want to spend on mortgage payments each month.
Evaluate your full financial situation, your ability to pay off a mortgage and where you need to save for other things.
Once you’ve done all that, go after that perfect home. Rocket Mortgage® by Quicken Loans is here to help you every step of the way.
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