The first step when contemplating buying a home is to figure out how much you can afford to spend. Knowing your price range will put your house hunt in perspective and help you narrow down your search. Determining your purchase price is crucial, as it directly impacts your affordable monthly payment and long-term financial stability. It is important here not to convince yourself you can “make ends meet” on a house that is really out of your price range. For this reason, you should always lower your price range a bit from the highest amount you can afford to pay in order to add in a little cushion. Make sure your purchase price results in an affordable monthly payment, taking into account principal, interest, taxes, and insurance, so you can comfortably manage all associated costs. Doing this will go a long way to reduce your financial stress down the road.
Table of Contents
How Do I Know What I Can Afford?
Lenders will typically tell you that you can afford a mortgage worth about three times your gross annual income. However, this is just a very general rule of thumb and should be viewed as a starting point when figuring out what you can afford. Remember that lenders do not always have your best interests in mind. After all, once you sign on that dotted line, they will get their money back one way or another. You need to be sure you can afford the mortgage. Do not just go off of what the lender tells you.
Everyone’s financial situation is different, so in order to truly know what you can afford you will have to take a good long look at your budget to see how much money you have left over each month to pay your mortgage. Don’t forget about the other expenses that go along with owning a house, such as:
-
insurance,
-
taxes,
-
maintenance, and
-
homeowners insurance.
Many lenders require escrow payments to cover property taxes and homeowners insurance, so it is important to budget for these ongoing costs.
If you don’t already have a budget, it is very easy to make one. Just create a spreadsheet with your total monthly income at the top, and then subtract all your expenses. Be as thorough and realistic as possible. Lenders will review your checking and savings accounts to assess your financial stability and your ability to cover mortgage-related expenses. Maintaining healthy savings accounts is an important part of your financial preparation for a mortgage. If you find yourself having to try to cut out a lot of expenses in your budget in order to be able to afford a potential mortgage payment, it is a big sign that you should find a house with a lower mortgage payment.
Understanding your payment options, including different loan structures and what costs are included in your monthly payment, can help you make a more informed decision.
Add Extra Monthly Savings Into Your Budget
Odds are that at some point over the life of your mortgage you will suffer an emergency expense or drop in income that reduces what you can spend on your mortgage. So go ahead and add in some extra monthly savings into your budget for times when money is tight.
Debt-to-Income Ratio
Lenders closely examine your debt-to-income (DTI) ratio when considering your mortgage loan application. This ratio compares your total monthly debt payments—including your proposed mortgage payment, credit cards, car loans, and student loans—to your gross monthly income. A lower DTI ratio shows that you have a manageable level of debt relative to your income, which increases your chances of loan approval.
Most lenders prefer a DTI ratio of 36% or less, though some mortgage programs may allow higher ratios depending on other factors like your credit score or cash reserves. To calculate your DTI, add up all your monthly debt payments and divide by your gross monthly income. For example, if your monthly debt payments are $2,000 and your gross income is $6,000, your DTI ratio is 33%. Keeping your DTI low not only helps with mortgage approval but also ensures your monthly mortgage payment remains affordable within your overall budget.
Understanding Credit Score
Your credit score plays a crucial role in qualifying for a mortgage loan and securing favorable terms. This three-digit number, typically ranging from 300 to 850, reflects your history of managing credit and making payments on time. Lenders use your credit score to assess your risk as a borrower. A higher score can lead to better interest rates, lower monthly payments, and a smoother loan approval process.
A strong credit score—generally 700 or above—signals to lenders that you are responsible with your debts and likely to make your mortgage payments on time. Factors that influence your credit score include your payment history, the amount of credit you use compared to your limits, the length of your credit history, the variety of credit accounts you have, and recent credit inquiries. Before submitting a mortgage loan application, it is wise to review your credit report, address any errors, and take steps to improve your score if needed. Even a small increase in your credit score can make a significant difference in the interest rate and loan options available to you.
Get Prequalified and Preapproved for a Mortgage Loan
Once you have figured out how much you can afford to spend on a mortgage and have found a home in your price range, you will need to get prequalified for a loan from a lender. Getting prequalified means that a lender will estimate how much it will let you borrow and how much you will need for a down payment and closing costs. The lender typically will not look at your credit score in order to do this, so these estimates may change once it investigates your financial situation more before approving your loan. The next step is to complete a mortgage application, which is required to formally begin the loan process.
At the same time, you should also ask for loan preapproval from the lender. Preapproval is not a full guarantee that you will get the loan, but it is the closest you can get to knowing that you will be approved, and the seller (and you) will want to know ahead of time that the deal will work out. To preapprove you, the lender will look at your credit and finances to get a better idea of your ability to repay the loan. Self-employed borrowers may need to provide additional documentation to verify their income and financial stability. For this reason, you should look at your credit score before approaching the lender for prequalification and preapproval. Lenders offer a variety of loan types, such as FHA, VA, and conventional loans, each with different eligibility requirements and features.
If your score is 740 or above then you should not have much of a problem getting approved, but if your score is closer to 620 then the lender might not approve you or may ask you to agree to pay a larger down payment or higher interest rate on the loan.
You can quickly check your credit score by visiting one of the three main credit bureaus: Equifax, Experian, or TransUnion. Many lenders also offer online banking platforms, making it convenient to monitor your financial accounts and credit status.
When considering interest rates, keep in mind that the advertised rate for a mortgage is based on specific loan assumptions, such as your credit score, down payment, and loan term. Borrowers can pay discount points at closing to lower their interest rate. There are different types of mortgages, including fixed-rate and adjustable rate mortgage (ARM) options. A fixed-rate mortgage offers a consistent interest rate and predictable payments throughout the loan term, while an adjustable rate mortgage has an interest rate that may change periodically, which can cause your monthly payments to fluctuate.
Once you are prequalified and preapproved you can finalize negotiations with the seller and close the deal. Working with real estate professionals can help guide you through the homebuying process. If you are having trouble getting approved, try talking with the lender about things you can do to improve your odds. It may only take something as simple as saving up for a larger down payment or changing your payment structure at work. Consulting family members for recommendations on lenders or real estate agents can also be helpful.
If you are considering a VA loan, active duty service members and their families should consult with a legal advisor before refinancing, as it may affect their SCRA benefits.
Remember, the loan term (such as 15 or 30 years) will affect your monthly payments and the total interest paid over the life of the loan. There are many home loan options available, and restrictions apply—eligibility and terms may vary based on lender and loan program.
Down Payment Requirements
The down payment is one of the most significant upfront costs when buying a home, and the amount you need depends on the type of mortgage loan you choose. FHA loans, backed by the Federal Housing Administration, require a minimum down payment of 3.5%, making them popular among first-time homebuyers. VA loans, offered through the Department of Veterans Affairs, may allow eligible borrowers to purchase a home with no down payment at all. Conventional loans typically require a minimum down payment of 5%, though some programs offer lower down payments if you agree to pay private mortgage insurance (PMI).
A larger down payment can reduce your loan amount, lower your monthly payment, and help you avoid the added cost of mortgage insurance. However, it is important to balance your down payment with other financial needs, such as saving for closing costs, property taxes, and maintaining cash reserves for emergencies. Consider your full financial situation to determine the right down payment for your homebuying budget.
Mortgage Insurance
Mortgage insurance is designed to protect lenders in case a borrower defaults on their mortgage loan, and it is often required when making a lower down payment. For conventional loans with less than 20% down, you will typically need to pay private mortgage insurance (PMI), which can be added to your monthly payment or paid upfront at closing. The cost of PMI depends on your credit score, loan amount, and down payment size.
FHA loans require both an upfront mortgage insurance premium and ongoing monthly payments, regardless of your down payment amount. VA loans, in contrast, do not require mortgage insurance, but they do include a one-time funding fee, which can be financed into the loan. By making a larger down payment or choosing a loan program that does not require mortgage insurance, you can reduce your overall mortgage expenses. Understanding your mortgage insurance options and costs will help you make informed decisions and keep your monthly mortgage payment as affordable as possible.