When trying to figure out how much home you can afford, there are a lot of factors to consider. This article will walk you through some things to think about before you start shopping for your next home.
Key Takeaways
- Your debt-to-income and housing expense ratios are key factors in determining how much money you can borrow.
- Multiple factors will impact how much your monthly mortgage payment will be. A careful analysis of your finances will help determine if you are able to afford the monthly payment.
- Remember—It is important to consider maintenance costs of your home, as well as your future financial goals, when figuring out how much home you can afford.
Debt-to-Income (DTI) Ratio
Let’s start with something called the debt-to-income ratio. Lenders want to be sure you can afford the payment on the loan they give you, and your monthly income is a key thing they’ll look at when deciding how much money you can borrow.
Your debt-to-income ratio is calculated by adding your monthly debt payments (which can include mortgage payment, car payments, student loans, and credit card debt), and dividing the total by your monthly gross income (the amount you make before taxes and other deductions are taken out). You then multiply that number by 100 to get a percentage. Lenders typically want your debt to income ratio to be less than 49%.
(Monthly Debt Payments/Monthly Gross Income) x 100 =
Debt-to-Income Ratio
Housing Expense Ratio
Lenders also want the housing expense ratio of your new home to be under 29%. This simply means it should cost less than 29% of your monthly gross income to afford the home you want to buy. Remember, this calculation includes more than just the mortgage payment. It can be calculated by adding the monthly principal, interest, taxes, insurance, and any homeowner’s association dues, then dividing by your total monthly income, and finally multiplying by 100.
Now let’s look at how your mortgage payment is affected by interest rate, term, and down payment.
Interest Rate And Points
A higher interest rate typically means a higher monthly payment, while a lower interest rate typically means a lower payment.
You’ll want to speak with your mortgage loan officer about your options, as different mortgage products have different interest rates. You may also be able to pay points to lower your interest rate.
Again, you’ll want to get the specifics from your mortgage loan officer, but generally speaking one point equals 1% of your loan amount. If you are borrowing $100,000 then one point would cost $1,000. It’s sometimes also possible to pay for half a point, or a quarter of a point, etc. Points are paid at closing, so they do increase your closing costs. The tradeoff of course is that you would receive a lower interest rate, which lowers your DTI ratio, and lets you pay less over time.
Mortgage Term
Your mortgage term is simply the amount of time it will take you to pay back the loan.
Increasing your term may lower your monthly payment, while reducing your term may raise it. For example, paying back a $100,000 loan in 15 years requires a larger monthly payment whereas spreading the repayment out over 30 years lowers the monthly payment.
Once again, you’ll want to crunch the numbers with your mortgage loan officer because a longer term usually comes with a higher interest rate and you’ll likely pay more interest over the life of the loan than you would with a shorter term.
Down Payment
The required down payment varies depending on which loan program you choose, but will typically be between 3.5 and 20%. First-time homebuyers may qualify for special programs that require an even smaller down payment, or even no down payment. An experienced mortgage loan officer can explain your options.
A low down payment increases how much you have to borrow, which could not only raise your monthly payment amount, but could also affect your housing expense ratio (see above). For this reason, you may want to consider saving for a down payment as soon as possible.
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Loan-to-Value (LTV) Ratio
Your down payment amount also directly impacts your loan-to-value ratio. This is simply a measure of the amount of money you’re borrowing divided by the appraised value of the home.
Borrowers with a LTV ratio above 80% (meaning they are borrowing greater than 80% of the value of the home) may be required to pay mortgage insurance, so it’s important to factor that into your monthly cost as well.
Closing Costs
Closing costs are another expense you’ll need to consider. Closing costs vary based on a number of factors, but typically range between 3% and 6% of the purchase price of the home. Talk with your lender, as you may be able to roll these costs into your mortgage if you are refinancing, or ask the seller to pay part of them if you are buying a new home.