Any number of first-time home buyers go into the process with no clear idea about how much house they can afford. Knowing that number will not only save you some time and emotional tumult but can also keep you out of financial hot water.
Back during the housing bubble many buyers were lured in with low “teaser” rate mortgages that adjusted to a much higher rate a couple of years later. The buyers could barely afford the “teaser” rate payments. There was no way they could swing the higher rates, and that helped set off a wave of foreclosures.
New regulatory guidelines for what constitutes a Qualified Mortgage – one that lenders are able to securitize – recently went into effect. While they make risky loans less likely they can also be a challenge for some home buyers. That's why you should know how much house you can afford before you begin looking at homes.
Lenders will help you through the process. Wells Fargo, for example, provides an online contact form where you can enter relevant information and get a quick answer. A Realtor can also help you arrive at your affordable price. While that may be the fastest and easiest way to go about it, it may be a good idea for you to understand the underlying mechanics.
It starts with how much money your household brings in each month. If two incomes are being considered, it is important that both be relatively secure. In this new environment underwriters like to see stable employment, preferably for two years or more.
Next, a lender will look at your monthly expenses and this is where many a would-be home buyer gets derailed. Other debt can often be a disqualifier. A couple of car payments and a large credit card balance can reduce the amount of house you can buy.
To calculate your debt-to-income ratio, you add up all your monthly debt payments and divide them by your gross monthly income. Your gross monthly income is generally the amount of money you have earned before your taxes and other deductions are taken out.
For example, if you pay $1500 a month for your mortgage and another $100 a month for an auto loan and $400 a month for the rest of your debts, your monthly debt payments are $2000. If your gross monthly income is $6000, then your debt-to-income ratio is 33%.
A debt-to-income ratio of 33% would make you look pretty good to a prospective borrower. Under the new Qualified Mortgage rules borrowers can have up to a 43% debt-to-income ratio and still get a Qualified Mortgage. The income-to-debt ratio is key to determining how much of a monthly payment you can afford.
Assuming you have job stability and a low income-to-debt ratio an underwriter will next want to know your credit score. Lenders have their own requirements for a minimum credit score to qualify for a conventional loan. However, the threshold is lower for an FHA or VA loan and that minimum number is subject to change.
Regardless, before getting serious about a home you should try to learn your credit score and, obviously, the higher the better. If you don't know your credit score it will be provided to you as part of the loan application process.
Interest rate and down payment
Assuming you have the qualifications to get a mortgage you next have to determine how much of a mortgage you can afford. The interest rate you will pay and the amount you have for a down payment will tell you how much house you can afford.
A high credit score will get you the best interest rate. If the prevailing rate on a 30-year fixed rate mortgage is 4.5%, you might have to pay 4.9% or more if your credit score is in the bottom range of acceptability.
If you have 20% of the purchase price as a down payment, that will help you get a good rate. If you only have 10%, your rate could be higher.
If you can qualify for an FHA loan – they're usually made to first-time home buyers – you could pay as little as 3.5% down. However, you would be required to pay for mortgage insurance and, since you would be paying a lot in interest, your total loan payment would be higher than if you put 20% down, affecting your income-to-debt ratio.
Use a mortgage calculator like this one to determine what your mortgage payment would be. Remember that the number is just for principal and interest. Mortgage payments also includes taxes and insurance, which can add another couple hundred dollars to the monthly payment.
The first step in the home buying process has nothing to do with looking at houses and everything to do with looking at finances. Working with a Realtor or lender will quickly tell you whether you can probably qualify for a mortgage and for how much.
Knowing how much you have for a down payment and how much monthly payment you can handle will then tell you the price range of the house you can afford.