How Much Home Can You Afford?
When you rent a home, no one asks questions or verifies whether or not you can afford to pay rent – other than confirming your employment and perhaps a credit check. Buying a home is very different. You’re borrowing a large amount of money and your lender will ask many questions and request even more proof to determine whether or not you can realistically afford to purchase a home. So, what will they take into consideration?
Generally speaking, you can afford a home if no more than 30-35% of your total income is used to pay debts.
Lenders will help you determine - and then take a hard look - at your debt-to-income ratio. Or, how much you are obligated to pay toward debt month-to-month compared to how much you’re bringing in. In most cases, having a 43% debt-to-income ratio or higher will make it incredibly difficult - or impossible - to qualify for a mortgage.
When looking at your income, the underwriter (the person who reviews your application to see if it fits the loan guidelines) reviews your gross income (the amount you make before taxes are taken out) and your actual take-home pay (including any additional income, like freelance income, alimony income, and so on). Debts include car loans, student loans, and credit card payments.
Then there’s the mortgage payment. Once you’ve determined whether or not you’ll qualify for a mortgage, it’s important to consider whether you are comfortable with adding a monthly mortgage payment into your budget. Your monthly mortgage payment is actually a combination of four different elements:
- Principle: The amount you’ve actually borrowed. Each month, a part of your mortgage payment goes toward paying back the actual (principle) loan amount.
- Interest: The amount of your monthly mortgage payment that goes back to the lender. Essentially, you’re paying them interest for taking the risk of lending you a large sum of money.
- Taxes: Real estate taxes vary by state but are usually a percentage of the tax-assessed value of your property.
- Insurance: Homeowners insurance, flood insurance, and other insurances are required when you have a mortgage. Private mortgage insurance (PMI) may be required if you put less than 20% toward a down payment.
Combining all of this information and having an in-depth discussion about your current financial situation will allow a lender to determine how much money they are willing to loan you, and at what rate.
Having a monthly budget in place before diving into the home-buying process is crucial to determining how big of a loan you’re willing to take on as well as how much you’re comfortably able to pay on your mortgage month-to-month. Just because you qualify for a $200,000 home loan doesn’t mean you have to shop homes in that price range and take out the full amount. Determine what number you (and your partner) are comfortable with and stick to it.
Curious to know how much you will qualify for? Take a quick look at your own numbers by utilizing this affordability calculator.