When it comes to taking on a mortgage, you need solid information in your corner. Lenders will offer you the largest possible loan based on how your finances look on paper. Their goal is to lend you a lot of money for a long time and collect tens of thousands of dollars in interest.
Your goal is the opposite: to take out the smallest mortgage you can, and never more than you can easily afford to pay back. That might mean buying a smaller house or looking in an area with a lower cost of living, which might feel disappointing right now but will be a huge stress saver down the line.
Here is everything you need to know to determine how much mortgage you can afford.
How Much Mortgage Can I Afford?
As a general rule, most prospective homeowners can afford a mortgage that is between two and two-and-a-half times their annual gross income. The formula states that an individual earning $100,000 a year can only afford a mortgage between $200,000 and $250,000. It is, however, just a general guideline.
Aside from the price, there are several other factors to consider when choosing a property. To begin with, you should understand what your lender believes you can afford (and how that assessment was made). In addition, you should do some introspection and determine what type of house you would be willing to live in and what other types of consumption you would be willing to cut back or eliminate in order to live in your house.
How Do Lenders Determine Mortgage Loan Amounts?
Every mortgage lender uses slightly different criteria when determining how much money and what loan terms they’ll offer, but they all look at the same basic information.
That starts with your gross income: your total paycheck before taxes, retirement plan contributions, and other deductions are taken out. From there, they try to figure out the biggest mortgage payment you can afford by factoring in things like property taxes, your current debts, and your credit score.
The Front-End Ratio
Lenders first look at how much of your annual gross income can go toward repaying the loan to determine your maximum mortgage payment. They base that on the full mortgage payment, known as PITI, which includes:
- Property Taxes
- Insurance (both homeowner’s and mortgage insurance)
They compare your gross income to the PITI to come up with the front-end ratio, the percentage of your income needed to cover the mortgage payment. Many lenders allow that ratio to range between 30 and 40 percent—but that’s much higher than most borrowers can easily afford.
For example, let’s say your gross annual income (which may include your salary, bonuses, business income, side gigs, alimony, and child support) comes to $75,000. That works out to $6,250 per month.
Thirty percent of that comes to $1,875, and 40 percent comes to $2,500 per month. Remember, though, that’s based on your gross income, not how much money you actually take home, so their idea of affordable may not mesh with your budget.
The Debt-to-Income Ratio
Your debt-to-income ratio, or DTI ratio, measures the percentage of your gross income that goes toward paying debt. Most financial experts and lenders recommend keeping your DTI ratio under 36 percent of your gross income, but some lenders will let your DTI ratio be as high as 43 percent. You can calculate your DTI ratio by dividing your total monthly debt payments by your gross income.
What counts as debt here?
- The new mortgage payment
- Loan payments (including car, student, and personal loans)
- Credit card payments
- Alimony and child support
- Any other monthly obligations (like back tax payments)
Total up your monthly debt payments, then divide that number by your monthly gross income. For example, if your total debt payments come to $2,600 and your monthly gross income is $6,250, your DTI ratio would be 41.6 percent.
Your credit score plays a huge role in determining how much the mortgage will cost you. Lenders look at this to assess your risk factor—how likely you are to pay the mortgage in full and on time every month.
Your risk factor translates directly into your interest rate: People with lower credit scores almost always pay higher interest rates. That can add thousands, even tens of thousands, of dollars to the total lifelong cost of your mortgage.
Most conventional lenders look for credit scores of 620 or above. Government-sponsored loans (like Federal Housing Administration [FHA] loans) allow for lower credit scores, lending to people with scores in the 500s.
Learn more about how to read your credit scores.
How to Calculate a Down Payment
When it comes to down payments, they are the cash or liquid assets a purchaser is able to contribute to the purchase price of the residence. Most lenders require a 20% down payment on a home, but some will let buyers purchase a home with a significantly smaller percentage.
By putting down more money, you will need less financing, and your credit rating will improve. The down payment on a $100,000 home is $10,000 if a prospective buyer can afford to pay 10%. Therefore, the homeowner must finance $100,000.
In addition to the amount of financing, lenders also want to know the length of time the mortgage loan will be needed. While the monthly payments on a short-term mortgage are higher, the overall cost is likely to be lower.
How Lenders Decide
Mortgage lenders consider multiple factors when determining a homebuyer’s affordability, but it boils down to income, debt, assets, and liabilities.
Lenders want to know how much income an applicant makes, how many demands are placed on it, and whether or not that income may diminish in the future. In other words, anything that may compromise their ability to get paid back.
The income, down payment, and monthly expenses that qualify for financing are generally based on these factors, while credit history and score determine interest rates.
Pre-Mortgage Considerations For Homebuyers
When you’re considering taking out a mortgage, you’ll need to do some different math than the lenders do. Your number one question will be how much mortgage your family can truly afford, not how much mortgage can you get.
Your calculations will be based on your net income, the amount of money you have left after taxes, and other deductions because that’s the only money available to put in savings or pay bills. You will look at all of your expenses, consider all of your financial plans and goals, and come up with a more realistic maximum mortgage payment for your budget.
DTI leaves out most of your regular monthly expenses. It doesn’t take into account your cell phone bill, cable, and Internet, groceries, utilities, prescriptions, school clothes, vet bills, or the dozens of other things you spend money on regularly.
Remember, lenders may seem to care about what’s best for your budget, but they really care about selling you a loan so they can make money. It doesn’t seem like that when you’re trying to get approval; it feels like you’re trying to convince them to finance your house. Remember this: The bank is not on your side, and the bank always wins.
Are you relying on two incomes to pay your bills? Do you have a stable job? If you lose your current position, will it be easy to find a similar or better job? Every dime you earn has to be used to meet your monthly budget, so even a small reduction can have disastrous consequences.
You need to consider the difference between your gross and net income. For most people, that difference runs between 25 and 30 percent after federal and state income taxes, Federal Insurance Contributions Act (FICA) taxes, and deductions for retirement plan contributions and health insurance are subtracted. That means that right off the top, you already have 25 to 30 percent less money available to cover expenses.
Think about any new expenses you’ll have. For example, if you’re moving to an area with a higher cost of living, factor that into your budget. If you’re moving from a rental, add in the costs of maintaining and repairing the place you plan to buy, which may include:
- Yard work
- Snow removal
- Homeowners association fees
- Plumbing and electrical repairs
If you’re moving to a bigger place, you’ll also need to account for things like higher energy costs and possibly additional home furnishings. All of these extra costs will flow into your monthly budget and need to be considered when you’re figuring out how much mortgage you can afford.
Your spending style will also play a key role in the affordability of your mortgage. If you like having a lot of disposable income to spend on going out or buying whatever you want, a large mortgage payment combined with the many other expenses of homeownership can put a serious crimp on that. While you might technically be able to afford the mortgage, it may be all that you can afford if it eats up too much of your income.
No two people are alike, regardless of their income. It is one thing to know that you owe $5,000 per month for the next 30 years, but it is another to fret over a payment of half that amount. People would go crazy if they had to refinance their home to afford payments on a new car, while others would not be concerned.
Costs Beyond the Mortgage
1. Closing Costs
Closing costs often get overlooked when people are looking into mortgages, but they should be part of your search for the best loan. There are a lot of expenses (like transfer taxes and recording fees) associated with buying a home, and those costs have to be paid at the closing (when all of the legal documents are signed and the big money changes hands).
Closing costs normally add between 3 and 5 percent of the sales price to your deal, and if you (as the buyer) are paying the realtor’s fees, they can run as high as 10 percent. Some lenders will offer to “wrap” the closing costs into your loan.
That seems like a welcome convenience, but it will cost you a lot more money in the long run in extra interest. A better choice: Find out the total estimated closing costs and bring enough cash to the closing to cover them.
2. Property Taxes
It is important for a homebuyer to understand how much property taxes they will owe when they own a home. Depending on your home and lot size, and other factors, such as local real estate conditions and the market, your property tax is set by your city, township, or county.
Approximately 1.1% of a home’s assessed value is the effective average rate for property taxes nationwide, according to the Tax Foundation. Property taxes vary from state to state, and some have lower taxes than others. It is an average of 1.4% in New York, but 0.88% in Oklahoma.8 So you will always be responsible for paying property taxes, even when your mortgage is paid off.
3. Home Insurance
Every homeowner should have home insurance to protect their assets against natural and manmade disasters, such as tornadoes. When you’re purchasing a house, you’ll need to determine what kind of insurance is appropriate for your situation. You won’t be able to purchase a mortgage without insurance that covers the purchase price of the home. Depending on your mortgage lender, you may need to show proof of home insurance.
In 2018, the most recent statistics available as of early 2021, the average home insurance premium in the U.S. was $1,200.9 However, the amount varies depending on the type of insurance you need and your state of residence.
No matter how new the home is, nor the expensive and significant appliances, such as refrigerators, stoves, and dishwashers, will last forever. Roofs, furnaces, driveways, carpets, and even paint on walls all need maintenance. You could end up in a difficult situation if your finances have not improved by the time you need major repairs on your home if you are house poor when you take on that first mortgage payment.
Heating, insurance, electric power, water, sewage, trash removal, cable TV, and telephone service all cost money. Both of these expenses are not factored into the front-end or back-end ratios. They are, nevertheless, a necessary part of owning a home.
Furthermore, bigger houses require more heating and cooling energy to maintain their temperature. People tend to ignore this fact when they see a big, charming house.
6. Association Fees
Condominiums, cooperatives, and certain gated communities charge monthly or yearly dues. The fees vary from a few hundred dollars per month to less than $100 per year. Other services offered by some communities include lawn maintenance, snow removal, and a community pool.
Fees are used to cover the administrative costs of running the community. In addition to the association fees being included in a growing number of lenders’ front-end ratios, these fees are expected to increase in the future.
7. Furniture and Decor
Consider how many rooms you will need to furnish and how many windows you will need to cover before you buy a house.
Learn more about the complete costs of buying a home.
Most people will have to deal with the cost of a home as their largest personal expense. Take the time to do the math before taking on such a massive debt. Having run the numbers, think about your situation and your lifestyle not only now, but in ten or twenty years.
Consider not only the cost of purchasing your new home, but also how your future mortgage payments will impact your budget and life. To get real-world information about the types of deals you can get, get loan estimates from several different lenders for the type of home you are planning to buy.