How Much Home Can I Afford?

The short answer is, it’s complicated. But let me walk you through some of the basics. Lenders are looking at three key components when considering a mortgage approval: income, assets and credit.

1. Credit score and the liabilities (debts) showing on your credit report have a large impact on your max approval. Lower credit scores often mean that a larger down payment will be needed, and/or your maximum debt ratio (more on that later) will need to be lower. With the exception of VA loans (for veterans and active duty military), a credit score below 580 will require a minimum 10% down payment in almost all cases.
2. Assets, and particularly the amount available for down payment, also plays a key role. A larger down payment will not only lower your debt ratios, it is also an indication of a lower risk loan which often results in a higher maximum loan approval. Additionally, extra money in the bank can also be used to payoff debts, which will more often than not have a greater impact on your maximum approval than simply making a larger down payment.
3. Income typically has the greatest impact on your approval. Most loan programs require that no more than 50% of your gross income go towards mortgage payment(s) plus the liabilities showing on credit. For example, if you make $8,000/mo (before taxes), the lender will want to see that your new mortgage payment plus all debts (auto payment, credit card payments, student loans, etc.) are no more than 50%, or $4,000, of your gross monthly income. A few loan types, namely FHA and VA, allow for debt ratios higher than 50%. And most no money down programs like USDA and down payment assistance programs require debt ratios significantly lower than 50%.

So, how much home can you afford? The best way to find out is to contact a local mortgage professional. But if you are looking for a good rule of thumb – take your gross monthly income and divide by two – so in our $8k/mo example above, 50% is $4k. Now subtract the monthly payments showing on your credit report. Let’s say you have a $500/mo car payment, $150/mo in student loan payments, and $150/mo in credit cards payments. $4,000 – $500 – $150 – $150 = $3,200. So $3,200/mo would be around the maximum mortgage payment allowed, perhaps slightly more if you are eligible for an FHA or VA loan.

But, just because you could be approved for this amount, it does not mean that is the right price for you. Ask yourself what monthly payment you are comfortable with, and a good lender will work backwards from there. During my initial consultation with clients, I always ask what their goals are in regards to monthly payment and cash out of pocket. In many cases the goal payment is much lower than what you can technically afford per lending guidelines. And it’s a big red flag if the only consideration your lender has is your max approval.

And a few more tips here that may seem counterintuitive when it comes time to make an offer. Seller paid closing costs are typically more important than purchase price. Meaning if you are considering a $400k offer with no seller paid closing costs, or a $410k offer with $10k of seller paids, the latter will almost always provide a lower payment. And don’t get too hung up on down payment, particularly the 20% goal that many buyers have in order to avoid PMI. If you have other high interest debt, you may be better served by paying off that debt and making a smaller down payment (even if that means paying PMI).

If you want to know more, just give us a call 🙂