How Much House Can I Afford?

Highlights:

• One of the most important steps in the home-buying process is to ask yourself a simple question: How much house can I afford? The answer is often more complicated than simply knowing how much money you have in the bank or how much you pay each month in rent.
• Your credit scores, debt-to-income ratio and the size of your down payment, as well as the closing costs associated with your home purchase, are all factors that impact how much house you can afford.
• Although there's no specific credit score needed to buy a house, credit scores are a factor in what type of loan you may be eligible for, as well as the interest rate and terms.

How much house can I afford?

One of the most important steps in the home-buying process is to ask yourself a simple question: How much house can I afford? The answer is often more complicated than simply knowing how much money you have in the bank or how much you pay each month in rent.

To determine how much house you can afford, you first need to find out how big a mortgage the lender will approve (based on current interest rates and your income). Then add to that the amount of cash you've set aside for your down payment, which is the sum of money you pay toward a home purchase up front. Remember, the lender will also require you to keep several months' worth of extra money in cash reserves in case you lose your job or experience a drop in income, so be sure to account for that.

Most lenders follow a simple guideline, known as the 28/36 rule, when it comes to deciding what size mortgage to approve.

According to this rule, you can spend up to 28% of your gross monthly income (your annual pretax income divided by 12) on your mortgage payment, property taxes and homeowners insurance premium. You can spend up to 36% of your gross monthly income on your total debt service, including those three items plus the monthly cost of any other debt you carry, including credit cards, student loans, personal loans and vehicle loans.

For example, if you and your spouse or partner earn $120,000 per year, your gross monthly income would be $10,000. Following the 28/36 rule, you'd be able to spend up to $2,800 on your mortgage payment, taxes and homeowners insurance and up to $3,600 on your total debt obligations each month.

Once you know how much you can spend on your mortgage payments, taxes and insurance, you have to consider interest rates, which are an important factor in determining how much you can borrow. For example, when interest rates rise, mortgages become more expensive and the amount of money you're able to borrow shrinks. Conversely, lower interest rates generally mean you can qualify for a higher mortgage amount because your monthly cost will be lower.

Your credit scores and debt-to-income (DTI) ratio (the total amount of debt payments you owe every month divided by your gross monthly income), as well as the closing costs associated with your home purchase, are all additional factors you'll need to consider when calculating how much house you can afford to buy.

What credit scores are needed to buy a house?

Although there's no specific credit score required to buy a house, there is a general range that lenders look for when deciding whether to offer you a mortgage.

The exact range needed to buy a house can vary, but lenders generally prefer credit scores of 620 or above and may reject anything below 580.

Your credit scores may also affect which mortgage types you qualify for and at what terms. In other words, higher credit scores generally mean you'll have access to more loan options and you're likely to receive better interest rates and more favorable terms, including a lower down payment. Additionally, your credit scores can affect whether you're required to purchase private mortgage insurance (PMI) and, if so, how much.

There are a few different types of mortgages you can apply for, but the most common are conventional/fixed-rate, interest-only and adjustable-rate mortgages; FHA loans; and VA loans.

Several months before you apply for a home loan, it's a good idea to take a look at your credit scores and credit reports.

How does my DTI ratio affect buying a house?

In addition to your credit scores, your DTI ratio is an important factor in figuring out how much house you can afford.

To calculate this number, tally your various debts — including credit card bills and outstanding student, personal, auto and other types of loans — and divide that number by your gross monthly income. Your gross income is the amount you earn before withholding taxes. Multiply the resulting number by 100 to obtain a percentage, and this represents your DTI ratio.

Like credit scores, the exact percentage an individual lender wants to see can vary, but federal home-lending guidelines require a DTI ratio of 43% or lower.

Mortgage lenders use your DTI ratio to help determine your loan terms and interest rates because it provides an indication of how much more debt you are able to take on. In other words, having a higher DTI ratio can make it more difficult to secure a mortgage with favorable rates. It's also important to remember that there is often a correlation between your DTI ratio and your credit scores. In some cases, carrying a large amount of debt compared to your gross income can negatively affect your credit scores.

How much money do I need for a down payment?

The size of your down payment is important, as it can impact your interest rate. A bigger down payment will typically lead to a lower interest rate, because the lender knows that the more equity (or cash) you have in the property, the less likely you are to stop paying your mortgage and walk away from the property. For most conventional loans, if you want to avoid paying PMI, you will need to put down at least 20% of the purchase price.

Lenders use something called a loan-to-value (LTV) ratio when considering your down payment, which is calculated by dividing the amount of the loan by the appraised property value. For example, if you're buying a home valued at $100,000 and you make a 20% down payment ($20,000), the LTV ratio would be $80,000 (the amount of the loan) divided by $100,000, or 80%.

If you're able to increase your down payment to 30%, the LTV ratio would drop to 70%, and the lender might offer you a lower interest rate.

What other costs should I consider?

It's important to note that there are a number of expenses that come with buying a home that have nothing to do with the down payment or the mortgage. These include everything from transfer taxes, attorney fees, title insurance and other closing costs to inspection fees, annual property taxes, homeowners insurance, and ongoing repairs and maintenance.

Make sure you look at what you'll have to spend on these additional obligations and account for them as you determine how much house you can afford in terms of a down payment and mortgage.

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