How Much House Can I Afford?
If you’ve been contemplating buying a house, you’re no doubt asking the question, how much house can I afford? Good on you if you are, because that’s a question you need to ask and get an answer to before you look at even one property.
For the typical homebuyer, the value of the home that can be purchased depends primarily on how much financing you can qualify for. So, it’s a more complicated analysis than most other types of purchases.
But to simplify the process and to take some of the mystery out of it, I prepared this guide to help you navigate and understand the process before you even get started.
Figuring out How Much House You Can Afford
1. Your Employment History
Mortgage lenders typically look for a minimum of two years of stable employment history. That doesn’t mean you need to hold the same job for at least two years. But if you do change jobs during that time, it’ll be expected that your income will either be stable or showing a pattern of increasing.
There are exceptions to the general rule. For example, if you graduated from college or were discharged from the military within the past two years, both will count toward your employment. In some cases, a mortgage lender may even accept a promise of employment for a first job, as long as the position is related to your college major or military specialization.
The situation gets a little bit more complicated if you’ve changed careers within the past two years. If so, the lender will look for evidence you’ve established yourself in the new field. The specific documentation requirements are somewhat subjective here. The lender may want to see that you have been successfully employed in the new field for at least one year. They may also request a letter from your employer confirming that you have successfully made the transition and that you are expected to remain employed for the foreseeable future.
If you’re self-employed, the lender will generally require a minimum of two years in the same business. However, with certain compensating factors (see #7 on that topic below), they may accept less, but never less than one year.
2. Your Income
If you’re a salaried employee, the lender will accept your most recent pay level based on your most recent pay stub. But if you’re self-employed, commissioned, or earn significant investment income, they’ll average your income over the past two years.
If your income is averaged, but the most recent year shows less income than the previous, they’ll use the lower income. However, if the lower income in the most recent year generates concerns about your ability to continue to maintain that income level, the lender may reject your application for unstable income.
When you’re making an application for a mortgage, be sure to provide all the documentation requested by your lender. That will speed up the process and increase the likelihood your loan will be approved.
Typical income documentation will include the following:
- A copy of your most recent pay stub, which must include year-to-date earnings.
- W2s covering the past two years.
- The lender will perform a telephone verification of your employment directly with your employer.
- If you’re self-employed, the lender will require complete personal and business income tax returns for the past two years. They may also require a copy of your most recent business license, and may verify your business through your CPA or other professional.
- Income tax returns for the past two years may also be required if you have substantial investment income, rental real estate income, or earn a significant amount of your W-2 income from commissions.
3. Your Debt-to-Income (DTI)
Once your income has been calculated based on the processes described above, the lender will compare your proposed house payment and your total monthly debt obligations to that income.
This is sometimes referred to as “28/36”. Those are the ratios considered optimal when applying for a mortgage. For example, the first number, 28%, is your new house payment divided by your stable monthly income. If your stable monthly income is $6,000, and the new house payment is $1,500, your housing ratio is 25% ($1,500 divided by $6,000). That number is safe because it’s within the 28% guideline for housing.
But the second percentage, 36%, is often given more weight. That’s your new house payment, plus recurring monthly debt obligations, divided by your stable monthly income. For example, if your stable monthly income is $6,000, your new house payment will be $1,500, and you have $600 in recurring monthly debts, your total DTI will be 35% ($2,100 divided by $6,000). That ratio will be acceptable.
DTI is a well-recognized industry standard, but it’s just a guideline.
Keep the following in mind when considering your DTI:
- Non-housing obligations for mortgage purposes include mostly debt payments. That includes monthly payments on student loans, auto loans, credit cards, personal loans, and similar obligations. But it also includes court-ordered monthly payments, like child support or alimony.
- Expenses not included in DTI. You can ignore other regular payments, like life insurance, utilities, and voluntary payroll deductions.
- There is some flexibility on DTI ratios. On many (but not all) loans, lenders will allow your total DTI to go as high as 41% to 43%. But when they do, it’s usually because there are compensating factors (again, see Section 7 below).
- To improve your DTI, pay off some debt before applying for a mortgage. The best loan types to pay off are installment loans. The lender won’t recognize the payoff of credit cards and other revolving obligations unless they’re done well before making an application for the mortgage.
- Don’t go up to the maximum DTI. Use DTI ratios as the upper limit of housing affordability. Though it’s what a lender may allow, it will generally work better for your budget if you come in under the maximum limits. Look at your own current budget, and decide how much house payment you can afford, even if it’s well below allowable DTI levels.
4. Your Credit History
We’ve just covered income, employment, and DTI in some detail. But you should be aware that you may not be approved at the highest DTI levels if you have low credit scores. The higher your credit scores, the more flexibility lenders will have.
Your credit score will also affect the interest rate you’ll pay on your home loan. The effect can be quite dramatic.
According to myFICO.com, interest rates and monthly payments on the same loan amount can vary substantially at different credit score levels:
|If your FICO® score is…||And Your interest rate is…||Then your monthly payment will be…|
|760 – 850||2.78%||$886|
|700 – 759||3.01%||$911|
|680 – 699||3.18%||$932|
|660 – 679||3.4%||$958|
|640 – 659||3.83%||$1,010|
|620 – 639||4.37%||$1,078|
If your credit score is below 620, you won’t be able to qualify for conventional mortgages. The minimum cutoff is usually even higher with jumbo loans.
FHA and VA mortgages have more flexibility, but even those will be difficult to approve if your credit score is below 580.
Even apart from your credit score, major negative credit entries can also limit loan approval.
For example, on conventional loans, there is a four year waiting period after discharge from bankruptcy. However, that can be reduced to two years if the bankruptcy was caused by extenuating circumstances. Those would include a serious medical episode or an extended period of unemployment.
The same is true with foreclosures. The general waiting period is seven years, but it can be as little as three years with extenuating circumstances.
Apart from bankruptcy and foreclosure, you should do what you can to improve your credit score before making an application. Not only will that increase the likelihood of approval, but as you can see from the screenshot above, an improved credit score can result in a lower interest rate and monthly payment. Those improvements should be made as far ahead of your application as possible, so they’ll have the greatest positive impact.
5. The Increase in Your Monthly House Payment
Though the increase in your monthly housing payment isn’t a formal mortgage underwriting criterion, it can play a significant role if your qualification is tight.
For example, if your credit score 650, you’re purchasing a home with a 5% down payment (maximum financing), and your DTI is higher than 28/36; the increase in your monthly house payment is a factor that will be closely evaluated by your lender.
If the new house payment is increasing by only 10% or 20% over your current house payment, the lender may approve your loan. But if the increase is 50% or 100%, the lender may deny the application and recommend a smaller loan amount.
A big increase in house payment is a budgetary shock. If your application demonstrates a tight squeeze into the new loan, the lender may doubt your ability to manage the dramatically higher payment. But if the payment increase is modest and appears manageable, approval will be more likely.
Of course, apart from lender considerations, the increase in your monthly house payment should also be an important factor for you. If you’re having any difficulty at all managing your current house payment, whether it be your rent or your mortgage, you should be very careful about increasing it on the new payment to a level that may cause you to struggle.
6. Funds for Your Down Payment, Closing Costs and Escrows
Typically, conventional and jumbo loans require that at least some of the down payment (3% or more) come from your own funds. Those are savings you’ve accumulated prior to purchase. But the balance can be provided through a gift from a family member or a family-type friend.
If you’re applying for an FHA loan, the entire down payment can come from a gift. You don’t need to put any of your own funds into the purchase.
VA and USDA home loans require no down payment.
Minimum Down Payment Requirements for Each Major Loan Type:
- VA and USDA Loans: 0% down payment.
- FHA Loan: 3.5% down.
- Conventional Loan: 3% to 5% down on primary residences, but higher on second homes and investment properties.
- Jumbo Loans: can be as low as 10%, but 20% down is more typical.
Closing Costs and Escrows
Apart from down payment requirements, there are also closing costs and escrows to plan for.
Closing costs typically range between 2% and 3% of the mortgage amount. Escrows, which are allowances held for the payment of property tax and various types of property related insurance, are determined by what is customary in your local community, as well as the levels of both real estate taxes and required insurance policies.
If you’re purchasing a $300,000 home with a 5% down payment, you’ll need to have $15,000 for the down payment alone. But you may also need to have between $6,000 and $9,000 for closing costs, plus several thousand dollars for escrows (which are referred to as “prepaid expenses” in the mortgage industry).
Fortunately, closing costs and escrows can be funded through a gift. But they can also be paid by the seller or even the lender using lender paid closing costs (or lender credits).
But however you plan to cover the funds required to close, you’ll need to be prepared in advance.
Private Mortgage Insurance
Some variations of private mortgage insurance will be required on many loans. But how it’s collected varies from one loan program to another.
In the case of conventional and jumbo loans, the monthly premium will vary by a combination of factors, including the loan amount, loan type (fixed or ARM), and your credit score.
If private mortgage insurance is required on your loan, the payment must be included in your monthly housing payment for DTI calculation purposes.
Variations of PMI by Loan Type:
- VA Loans: a VA Funding Fee, commonly 2.3%, is added to the loan amounts and financed over 30 years. There is no additional monthly charge.
- FHA and USDA Loans: Both FHA and USDA Loans charge both an upfront mortgage insurance fee, which is added to the loan amount, plus a monthly fee that is included in your monthly mortgage payment.
- Conventional and Jumbo Loans: monthly mortgage insurance is required and will be paid as part of your mortgage payments if you make a down payment of less than 20% or if you refinance a property with less than 20% equity. There is no upfront charge.
7. The Property
So far, all qualifying criteria we’ve discussed has to do with either you as the borrower or the loan type. The property, however, is something beyond your control.
Even if you’re preapproved for a mortgage, you won’t know if the property is acceptable until it has been subject to an appraisal and, if required, any necessary additional home inspections.
Generally speaking, any property is acceptable for mortgage purposes as long as it meets minimum qualifications for safety and livability. If it doesn’t, those issues will need to be cured by the home seller prior to closing, or you’ll need to select another property.
Apart from the physical structure of the property, the sale price you are paying must be supported by the appraisal. An appraisal is a determination of a property’s market value by a licensed appraiser hired by the lender.
If the appraised value comes in below the sale price, the lender may require you to renegotiate the sale price to match the appraised value.
That’s why it’s critical to the home buying process to select a property that’s fairly priced and likely to appraise for the sale price or higher.
Though it’s common practice in real estate contracts, be sure any written offers you make on a home include a clause that lets you void the transaction if the property fails to appraise for the sale price.
8. “Compensating Factors”
This is a topic that I mentioned a couple of times earlier in this guide. For many mortgage applicants, it won’t be a factor. But if your loan qualification will be tight in any way, compensating factors are a way to get mortgage approval even if one or more parts of your application aren’t within guidelines.
A compensating factor is any tangible advantage that can offset weakness in your application. Weaknesses can include factors like a high DTI or a low credit score.
If you believe you may have difficulty qualifying for the mortgage of your choice for any reason, you should work to develop one or more compensating factors before applying for your mortgage.
Examples of Compensating Factors:
- A large down payment (20% or more).
- A small increase in your monthly house payment (10% or less).
- Cash reserves. These are liquid savings expected to be available after you close on the home. It can include bank accounts and even investment accounts, though retirement funds may not be recognized due to the tax implications of liquidation.
- A stable employment history, including a pattern of increasing earnings.
How Much House Can I Afford – Bringing it All Together
You can always contact a representative from a mortgage lender to help you learn how much house you can afford. But if you’re not quite at that stage, or you suspect there may be areas in your financial profile that need shoring up, it will help to use this guide to get some idea beforehand.
Not only will that make you a more informed buyer when you finally do sit down with a mortgage lender, but it will give you a chance to head off any potential problems before application.
That will be important, because you’ll have enough to worry about in finding your new home and making the physical move. The mortgage application and approval process should be as easy as possible. And if you follow the steps in this guide – and take full advantage of the Home Affordability Calculator to crunch the numbers, you should sail the mortgage application process in good shape.