Lucky for you, you can buy a house with a mortgage. You need to scrape together the deposit; the rest you can borrow from your bank. There are many lenders in the market offering various types of mortgages.
Mortgages are pretty advantageous. They offer an opportunity to spread the repayment on a property over many years. Then there's the matter of low-interest rates. Typically, mortgages charge lower interest rates compared to other forms of borrowing.
And yet, the benefits of mortgage borrowing aside, you have to be careful not to choose a mortgage you can't afford. The last thing you want is the bank having to repossess and sell your precious home to cover skipped payments.
Therefore, the big question is how much mortgage can you afford on your income?
Many different online sites offer a simple way to calculate your mortgage. You have to input your gross monthly income, expected housing costs, total down payment, and realistic expenses, then voila! – you get an estimate of how much house you can afford.
These online algorithms use the 28:36% rule that takes into your account your financial information, such as:
Your Gross Monthly Income
Your GMI includes wages, investments or dividends, alimony received, and all other revenue streams before taxes and other deductions such as contributions to your retirement plan.
A mortgage can be obtained using various income sources, including:
- Employee wages, commissions, bonuses, or overtime
- Income from self-employment and gigs
- Income and dividends from investments
- Rental property earnings
- Earnings from Disability benefits
- Social Security benefits
- Child support
- Alimony
If you are co-buying with your partner, include their income in the calculations.
Front-End Debt to Income Ratio
Eventually, it is up to you to decide how much your budget you want to spend on a new home.
However, lenders have a metric that helps them know if you can still afford additional debt on your monthly salary. To do that, they take the sum of your mortgage payments and divide that by your GMI.
Of course, your monthly mortgage payments comprise:
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The principal -this is the fraction of your regular mortgage payment to settle your loan balance. Initially, only a tiny fraction of your payments go towards principal payment, while interest takes the majority.
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Interest -this is the cost of the loan, i.e., what you pay in return for the loan.
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Taxes -a fraction of your regular mortgage payment may be used to settle your local and state property taxes depending on where you purchase your house.
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Insurance -some loans require the purchase of private mortgage insurance. The lender will claim this mortgage insurance if you default on the loan. Most conventional loans, for example, require those who cannot put down a 20% down payment to set up and pay private mortgage insurance until they have paid at least 20% of the house's value or for the life of the loan. Aside from that, homeowners' insurance is also required to protect your investment.
- Homeowners' association membership fees and other dues -If the property you purchase falls under homeowners or Condo association, HOA fees and other dues will be deducted from your monthly payment.
You can call these PITI. The front-end rule recommends that the ratio of your PITI to your GMI should be less than 0.28. Your PITI shouldn't cost more than 28% of your gross monthly income (GMI).
Your Fico Score
Another critical factor influencing how much you can borrow and thus buy a house is your credit score.
When you sign up to be preapproved for a mortgage, lenders will retrieve your FICO report, and your score will determine whether you qualify for a loan. It may also have an impact on the interest rate levied.
Your score is calculated based on things such as:
- Your debt payment history.
- The percentage of your credit currently in use.
- The age of your credit accounts.
- The types of credit accounts you own.
- The number of credits accounts you've opened recently (a fewer number is advised).
Lenders check your FICO score to ascertain whether you're a risky or dependable borrower. Most lending institutions typically demand a FICO score of 620 or higher.
Higher FICO scores attract lower interest rates than lower scores. This is because higher scores are associated with lower default risks. It's, therefore, a good idea to clean up one's credit history before applying for a mortgage.
Pay off your debts and request a copy of your credit report from the credit bureaus. You may have finished paying your debts, but the agency has not corrected your credit score.
In the event of such errors, request changes to obtain the credit score you deserve. You'll need payment history and other evidence to back up your claim.
Back-End Debt-To-Income Ratio
Another important rule is the back-end rule. Lenders will determine if you can assume additional debt based on how much your monthly income is servicing your outstanding monthly debts.
Of course, your outstanding monthly debt obligations include things like:
- Car payment,
- Student debt payment,
- Credit card payment,
- Alimony payment,
- Property taxes,
But don't include the gym membership fee and other utilities; only outstanding debt.
Usually, lenders favor borrowers with DTI below a certain maximum percentage to increase the chances of getting their money back. Many lenders recommend DTIs lower than 0.36. So take your total outstanding monthly debt and divide it by your GMI.
How Much Down Payment You Can Afford
Mortgage rates are also affected by the amount of down payment you make. Down payment refers to the value of the home paid upfront.
It is used to calculate loan-to-value (LTV) ratios. A mortgage with no down payment has an LTV ratio of 100 percent, which means the lender can lend you 100 % of your house's purchase price.
The majority of loans require a 20% down payment, though.
However, some conventional loans allow you to purchase a home for as little as 3% of the purchase price provided you set up private mortgage insurance, which will be added to your regular mortgage payments until you have paid off more than 20% of the property's value.
PMI payments add to your mortgage expenses. Therefore, it's always better to put down the 20% upfront fee to avoid PMI costs and boost your ownership stake in the house!
What does the algorithm not take into account?
Online mortgage calculators use a simple, summarized algorithm that considers the above information to calculate how much mortgage you can afford.
However, there are other essential factors you want to keep in mind when calculating how much mortgage you can afford.
Things like your lifestyle, personality, and post-mortgage expenses matter. You have to be honest with yourself.
While a 36% DTI may be suitable for many people, you might be the type that cannot survive a high debt-to-equity ratio. The last thing you want is to take on a mortgage expense you can't afford.
Here's the breakdown of other factors to keep in mind when calculating how much house you can afford on your salary:
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Your Personality -Different people have different personalities too. Some people can survive being house poor; others won't hesitate to refinance their house to live largely.
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Your Lifestyle -Are you a big spender or a conservative spender? Different people love different lifestyles. Some people can survive with a high debt-to-equity ratio; others can't. Your lifestyle determines the house you can afford.
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Post-Mortgage Expenses -DTI takes into account a person's present debt expenses only. But future expenses matter in house purchases too. These include a new car, vacation, and kids' tuition if you decide to get any.
- Home Maintenance Costs -Home maintenance expenses can get crazy too. When bundled together with PITI, they can take up a large chunk of your GMI beyond the 28%, leaving you with very little cash to pay outstanding debts and other discretionary expenses.
How to increase your capacity to buy a home?
If, after plugging your details into the online mortgage calculators, you didn't like the amount they gave you, there are things you can do to afford a bigger house.
Increase Your Credit Score
This is the first thing you can do to afford more mortgages.
Generally, people with higher credit scores get loans on better terms. That means lower interest rates and larger loans, among other advantages.
If you have a terrible FICO score, give yourself time to improve your credit history before looking for a mortgage.
Here are ways to improve your credit profile with lenders:
- Repair your credit,
- Pay off some or all of your existing debts.
- Keep your credit utilization below 30% of your monthly credit limit.
- Resolve any inaccuracies in your credit file.
- Avoid signing up for new credit unless necessary.
- Make an effort to increase your monthly income.
Save Up for A Larger Down Payment
Generally, lenders are more willing to take a risk on borrowers who put down bigger down payments. Most conventional loans require a 3% down payment. But you can save a bigger deposit if you can.
Expect more desirable mortgage rates because they'll be taking less risk, giving you the small amount needed to top up the house's price. Plus, a more significant down payment will reduce your monthly installment expenses.
If scraping together a substantial down payment is not easy, you can borrow at higher rates and refinance into better rate loans later.
There are also other programs to help first-time homebuyers who can't put together large down payments. You don't need to deposit 20% of the purchase price to be eligible for a mortgage; some schemes allow mortgages with very little deposit.
Be sure to confirm with the lender or local government. Also, check if they'll need private mortgage insurance. The latter is essential because private mortgage insurance would add to your monthly mortgage expenses.
Pay Off Your Debts
Lenders rely on DTI big time to determine how much mortgage to give you. Reducing your debts will increase your chances of getting approved for a mortgage. Just prepare a list of your debts and decide which one you can pay off.
Of course, it's wise to start with the most significant debt because paying it off will significantly reduce your DTI and get you closer to the benchmark. But you may have to reduce unnecessary spending to pay down your debts faster.
Purchase A Home in A Low-Cost or Low-Tax Area
If you're having trouble finding a home for a certain amount in a specific location, broaden your search.
When working on a budget, you may have to make compromises, like looking outside the city or your state, especially if you can work remotely.
What are alternative loan programs to buy a house?
Alternative loan programs make homeownership accessible to those who can't afford mortgages. These include FHA, USDA, and VA loans.
FHA Loans
Mortgages from the Federal Housing Administration are accessible to house buyers with FICO scores of at least 500 and little down payment.
If your FICO score is not above 580, you will be required to pay only 10% of the house value upfront and set up private mortgage insurance.
MIP payments are made to the FHA, which the lender will get in touch with and claim to settle your remaining balance in case of default.
For individuals with FICO scores above 580, the down payment requirement is only 3.5 percent. The DTI for FHA loans is 50%.
The FHA has several loan programs. Here's a look:
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Traditional mortgage used to finance the purchase of a primary residence.
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Home Equity Conversion Mortgage (HECM) - a converse mortgage for individuals aged 62 and up to turn their home's ownership interest into cash while keeping the property's title.
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FHA 203 (k) Improvement Funding - this loan includes additional funds for home improvements and repairs.
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FHA Energy Efficient Mortgage involves additional funds to assist you in making changes that will lessen your utility costs.
- Section 245(a) Loan starts with lower initial monthly payments that gradually increase as your earnings increase over time, reducing the loan's life.
VA loans
A VA loan is a type of home loan made available by a program created by the Veterans Affairs Department (VA). Veterans, active service members, and surviving spouses and children can apply for this loan to purchase a primary residence with little to no down payment.
The VA loan requires no private mortgage insurance and charges a decent interest rate. VA loans provide up to 100% financing on a purchase price. When applying for this loan, you'll have to present a certificate of eligibility from the VA Department.
The VA does not have DTI or credit score requirements. However, most VA lenders require a 43% DTI ratio and a FICO score of at least 580.
USDA loan
USDA loans are also available for those purchasing primary residences but only in rural areas. The USDA sponsors these and generally needs no down payment, which means you can get a mortgage equal to the home's market value you want to buy.
However, they come with additional fees, including a 2% assurance fee and a 5 percent annual fee. These additional fees help offset the higher risk associated with the greater LTV.
They also require a lower DTI ratio (43 percent) and higher FICO scores (640) than other mortgage loans, and you may be denied if your income is too high. The max amount you can obtain is 115 % of your county's median income.
Wrap-Up
How much house you can manage based on your income depends on many factors, including how much you earn, where you live, lifestyle, and personality. The 28:36 percent rule is a good guideline, but it doesn't cover everything.
Lenders will only consider gross income and debts when deciding how much to give and what rate to charge.
But personally, there are other considerations, including FICA deductions, taxes, and health insurance premiums, to consider. Also, can you rest easy knowing you owe thousands of dollars every month for the following 30 years or so?
It's wise to be realistic about your lifestyle and personality. The last thing you want is your mortgage payments to leave no allowance in your budget for food, healthcare, and other basic human needs.
