How Much House Can I Afford?
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.
How Much Debt Can I Take On?
You’ll first need to determine how much of your monthly income you can afford to spend on mortgage payments while at the same time allowing yourself a cushion for savings and emergencies.
When lenders evaluate your mortgage application, they calculate your debt-to-income ratio (DTI), 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 for your mortgage.
In order to get approved for a mortgage, it’s best to keep your DTI below 50%. Additionally, spending more than a third of your income on your housing may be risky if unexpected expenses arise or if you lose your job. Keeping your home debt payments below this threshold provides a good safety net for most individuals.
To determine your personal DTI, follow these steps:
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%.
Step 3: Determine Whether Your DTI Is Within An Acceptable Range
Lenders have to ensure that you’ll be able to pay back a loan. They typically use these guidelines:
- If your DTI is 50% or lower: You’ll likely be able to get approved for a mortgage. A lower DTI means less risk for a lender, so the lower that percentage is, the better interest rate you’re likely to get.
- If your DTI is higher than 50%: You need to actively come up with ways to lower your DTI. It’s extremely uncommon to find a lender willing to give you a mortgage if your DTI is higher than 50%.
Step 4: Work To Improve Your DTI Ratio
Do you need to boost your DTI? There are several ways you can actively improve it:
- Pay down as much debt as possible.
- Try not to take on any more debt and avoid large purchases.
As you work on reducing your debt, regularly calculate your DTI so you can see whether you’re making progress.
Mortgage Debt Vs. Recurring Debt
Think through your current debts. Debts that repeat every month are called recurring debts, and mortgages fall into this category. You must continue to pay on recurring debts until your financial responsibilities or agreements have been fulfilled.
Some recurring debt can increase your credit score. A lender uses this to assess how well you tackle your debt payments, and the lender also factors your recurring debt into DTI.
Variable expenses, on the other hand, are ones that can be more easily canceled or modified – think cable television, internet, insurance, any subscriptions, etc. These are not factored into DTI.
Compare With Your Budget
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.
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.
Mortgage Term And Interest Rate
These are the two main factors that determine your monthly mortgage payment.
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 – Rocket Mortgage® by Quicken Loans offers terms from 8-30 years.
Mortgage rate refers to the interest rate on your mortgage. Mortgage rates are determined by your lender and can be fixed or variable, which means that they can stay the same or change over the life of the loan. Your rate can vary depending on your DTI and other factors.
Changing Loan Term
Mortgage term and rate impact 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 (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 (excluding taxes and insurance).
Changing Interest Rate
This time, let’s change the interest rate. If you buy the $200,000 house with the 15-year fixed mortgage at 3.90%, what happens if we change the mortgage interest rate to 4.25%? Your payment goes up to $1,479.
There are many ways you can adjust the terms and interest rates to help determine what best fits into your budget.
Calculate Your Mortgage Payment: What’s Your Price?
Now that we’ve looked at your current debt and how term and interest rate affect payments, you can begin to assess how large of a mortgage you can take on.
Here’s another example. If you make $8,000 monthly and pay $2,000 in recurring debt each month, what mortgage could you realistically take on? More specifically, how much of a mortgage can you take on and keep yourself at a good DTI ratio?
First, let’s calculate your DTI for reference: $2,000/$8,000 equals 25%, which is excellent. If you wanted to keep you DTI at 35% after you take on a mortgage, you can take your current monthly gross income and multiply it by your ideal DTI.
Income x 0.35 = Comfortable amount of debt
$8,000 x 0.35 = $2,800
Since you already have $2,000 in monthly debt payments at 25% DTI, you can determine how to get to a DTI of 35%, which means you increase this amount to $2,800. In this scenario, a comfortable monthly mortgage payment would be $800 per month ($2,800 - $2,000).
Be Mindful Of Down Payments
You might think you need to plunk down 20% of your loan amount 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.
It’s 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 that 20%, you’ll pay something called private mortgage insurance (PMI), which can involve an upfront fee as well as an additional payment per month.
PMI protects your lender 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 tap into certain government loans. We’ll discuss those in a bit.
Don’t Forget About Extra Costs
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. The Rocket Mortgage® by Quicken Loans® Home Loan Experts can also discuss your specific case when looking into home insurance prices for your area.
- 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 steps 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.
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.
Tip #1: 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 will want to see a two-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?
Tip #2: Understand The Different Types Of Mortgages
If you don’t qualify for a conventional loan, or if you don’t want to make a large down payment, a government-backed loan may be in your best interest. These include:
- VA Loan: A VA loan is a mortgage option available to United States veterans, service members and their 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.
- 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. You’ll need a 580 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.
All three government-backed loans have mortgage limits, which is a handy way to help you stay in a healthy debt-budget range.
Tip #3: Consider 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 to 6 months’ worth of expenses. Your emergency money can go toward paying your mortgage if need be.
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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