How Much House Can I Afford?

How Much House Can I Afford?

The first step

Deciding to buy a house is the beginning of an exciting time in your life. There’s so much to think about: neighborhoods, school districts and styles of homes to name a few.

But before you begin looking at homes and neighborhoods, it is very important to take the first step in buying a home. You should determine how much you can comfortably afford to spend on a house. When you know how much house you can afford, you can save yourself time and headaches by looking only in areas and at homes that are legitimate options.

How much of a down payment do I have?

The down payment is the money that you must have up front to purchase a house. To qualify for a mortgage loan, you are usually required to have:

• A down payment of 5% to 20% of the purchase price of the home
• Closing costs of approximately 3% to 6% of the loan

Not everyone can afford to put 20% down on a house, so down payments as low as 5% or even 0% are often available with special mortgage programs. However, borrowers with smaller down payments who do not qualify for special programs are required to carry Private Mortgage Insurance (PMI). This involves an initial premium payment and monthly insurance premium payments. View helpful information on special mortgage programs requiring less of a down payment and other ideas on how to reduce your mortgage down payment.

You should look at the assets you will have available at the time of closing to determine how large of a down payment you can afford. This money can come from savings, investments, cash from the sale of your home or other real estate holdings, or it can even be a gift from relatives. Your down payment cannot be money that is borrowed.

What lenders look for

When you apply for a mortgage, you may feel as though your fate is in the lender’s hands. You need to know the answer to the big question: Will my application be approved?

You can feel far more comfortable about the answer to this question if you know what lenders look for when reviewing applications.

The driving force for lenders is confidence that loans will be repaid. They want to feel comfortable that the loans they make are safe, so they try to determine your ability and willingness to pay. Decades of lending experience have given the lending industry a pretty good idea of what borrowers can manage, and their experience is applied today in the form of qualifying ratios that are used to determine the amount of mortgage debt a borrower can typically handle.

Housing ratio

The first qualifying ratio is the housing ratio - the amount of money you can dedicate to housing expenses each month. It’s called a ratio because it is expressed as a percentage of your income. As a guideline, consider 28% of your gross monthly income to be the maximum acceptable housing ratio. This includes the various components of your monthly mortgage payment such as principal, interest, taxes, insurance and condominium fees. It does not include utilities, maintenance or other variable items.

For example, a couple with a combined gross monthly income of $2,000 a month could probably afford a maximum mortgage payment of about $560 (which includes taxes and insurance). If 28% of your income is dedicated to housing expense, that leaves 72% of your income to meet other expenses. This should be available to meet other monthly commitments, such as utility bills, food, clothing, medical care, transportation, entertainment and other household expenses.

Experience has proven that this is an acceptable level for many borrowers. After all, lenders recognize that you have expenses other than your mortgage payment, and they want to make certain that you can handle the load.

Debt ratio

The second qualifying ratio is the debt ratio, or the percentage of your income that you can typically spend on housing and long-term debt. Long-term debt includes car loans, student loans, credit cards and other similar debts. Any installment debt that will be paid off in less than 10 months is not included. Revolving debt is included. Your debt-to-income ratio is calculated by dividing your monthly debts by your pre-tax income. Click here to calculate your debt-to-income ratio. 

The purpose of the debt ratio is to see whether a borrower is overextended with debts other than mortgage debt. Most lenders look for a debt ratio 36% or less of your gross monthly income, but you can still get qualified if your ratio is higher. Other factors, such as a demonstrated ability to handle large monthly payments, are also considered. A couple with a $2,000 gross monthly income could typically afford up to $720 in mortgage payments and long-term debt.

Credit history

You determine your credit reputation by how you manage your financial affairs. Therefore, if you have shown the ability to establish credit and repay in a satisfactory manner, you can usually obtain a mortgage more easily.

A closer look at credit

When you apply for a mortgage, one of the things that lenders review is your payment record on things such as credit cards, car loans, rent and similar obligations. A good credit rating is acquired by making regular payments, on time and in the proper amount.

Items on a credit history that could be considered unfavorable include:

• A history of slow payments
• Previous defaults or foreclosures on mortgages
• Loans which have been written off by the lenders as bad debts
• Late charges
• Bankruptcies
• Liens
• Repossession of credit purchases

Of course, lenders will consider reasons that may explain a negative credit entry and encourage borrowers to provide such explanations early in the application process.

Beginning to establish good credit

Building a credit history takes time and patience. If you’ve never had credit before, you can begin to establish credit by starting small. You may want to open a charge account at one or two local department stores to demonstrate that you can handle credit responsibly. You may even be able to take out a small loan at a financial institution to further add to your credit history.

Another helpful step in establishing credit is to open a checking or a savings account. While these do not give you credit, they are often viewed by lenders as evidence that you know how to manage money wisely.

Recording your progress

As you use your credit, your borrowing and repayment habits are recorded and become part of your file at the Credit Bureau. Your credit file contains:

• Your name, address and social security number
• Details concerning your employment and income
• Specifics about your personal history, including birth dates, dependents and previous addresses and employment
• Information about your credit history, including how promptly you paid your debts and how much and how often you borrowed
• Specifics regarding any instances in which you may have been turned down for credit
• Information from public records, including bankruptcy and tax liens

The Credit Bureau will provide a written report to lenders about your ability to use credit responsibly.

Other factors

Lenders also look at employment history, for example, length of time with the same employer and stability in a line of work. They are interested in your residence history as well.

Try our mortgage calculators to calculate home affordability, mortgage payments and more. 

For additional assistance, talk to one of our mortgage experts.

This article is for general information purposes only and is not intended to provide legal, tax, accounting or financial advice.  Any reliance on the information herein is solely and exclusively at your own risk and you are urged to do your own independent research. To the extent information herein references an outside resource or Internet site, Dollar Bank is not responsible for information, products or services obtained from outside sources and Dollar Bank will not be liable for any damages that may result from your access to outside resources. As always, please consult your own counsel, accountant, or other advisor regarding your specific situation.