Table of Content
House prices can fluctuate over time, which can make planning a home purchase a challenge. However, there is data that shows the most common price brackets of property purchases. In this chart showing 2020 NAR Trends data, you can see that the most common price bracket for home purchases is $200,000 to $250,000 at 15%. However, this is closely followed by the over $500,000 bracket at 13%. The least common price bracket is the $75,000 to $100,000 at 3% of property sales.
The General Rule :2 to 2.5 Times
Generally, most prospective homebuyers can afford a mortgage that costs between 2 to 2.5 times of their gross income. Using this rule, a person who earns $100,000 per year can afford to borrow $200,000 to $250,000. But this is just a basic guideline – if you want a more definite figure, you have to consider many things.
Or, try to look at it this way. Put together the current interest rates plus strict underwriting rules plus the down payment you can come up with, then your income, debt and credit scores. Taking all of that, how much mortgage would a lender be willing to approve for you?
Can You Rely on Online Calculators?
Many prospective homebuyers try to do a shortcut by using an online mortgage calculator. Plugging in your monthly income, expenses and what you think your credit score is would get you an amount. But it may not be exactly what an actual lender would lend to you. You will also miss out on the insights you can get with an actual evaluation of your case. There are a lot of flexible, case-to-case factors that many lenders use in the approval process.
Eventually, when buying a property, there are still many more factors you should consider.
First, it’s good to understand what your lender thinks you can afford and how they computed for that amount. Next, you need to find the non-financial criteria for evaluating your account such as your preferences and priorities.
What is The 28%/36% Rule?
The 28/36 rule is a simple equation to determine mortgage affordability. In simple terms, your mortgage payment should be less than 28% of your pre tax, monthly income and less than 36% of your total debt. This is a calculation of your debt to income ratio, which is an important factor for potential lenders.
This rule is important not only for increasing your chances of mortgage approval, but it also helps you to understand whether a mortgage deal is affordable.
Your DTI ratio and income are only two factors that your lender considers when they calculate what type of monthly payment you can afford. If you have a higher credit score or a larger down payment, you may still qualify for a loan with more debt or a lower income. The options available to you will depend on your mortgage lender’s standards.
Remember that the 28% “rule” is only a suggestion to keep your monthly payment affordable. The specific percentage of income that you’ll spend on your mortgage depends on your unique household budget and how much debt you have. However, the 28% suggestion is a great jumping-off point when you start to shop for a home loan.
|Monthly Pre-Tax Income||Estimated Home Value (36% Rule)||Monthly Payment (36% Rule)||Estimated Home Value (General Rule)||Monthly Payment (General Rule)|
The table above used %10 as a benchmark for monthly debt payments. The mortgage section assumes a 20% down payment on the home value. Calculated interest rate is 3.8%.
What Is The Maximum Amount I Can Borrow?
Each bank would usually have its own criteria for lending and many of them consider many things. So, the amount and terms of the loan they can give a borrower would depend on different factors.
Here is an overview of what most of them look for so you can quite accurately predict whether you qualify for a loan or not and the forecast the amount you'll be able to borrow:
Gross income is that income a person makes before he or she pays income taxes.
It is made up of the total salary plus bonuses, any part-time income or self-employed earnings, Social Security benefits, alimony and child support. The gross income is integral in the determination of the next item.
The front-end ratio is the percentage of the monthly gross income that you can earmark to pay your mortgage every month.
A mortgage payment has four components (commonly known as PITI) or specifically: principal, interest, taxes and insurance.
The insurance part actually refers to your property insurance and private mortgage insurance (PMI). A basic rule to follow is that the PITI should not exceed 28% of the gross income. However, many lenders allow borrowers to exceed 30% and a few of them even go as high as 40% (See how to avoid paying mortgage insurance).
Also called the debt-to-income ratio (DTI), it measures the percentage of your gross income that is required to cover your debts. Debts would include credit cards, loans (auto, student, etc.), child support, etc.
For example, if you make $5,000 a month but pay off $2,500 each month for your outstanding debts, your ratio is 50%. This means that half of your monthly income goes to debt repayment.
The bad news is, a 50% debt-to-income ratio is probably not going to make your dream home a reality. Most lenders would like to see a debt-to-income ratio of not more than 36% of your gross income.
Here is a simple formula to calculate your maximum monthly debt based on this ratio. Just multiply your gross income by 0.36 and then divide it by 12. So, if you earn $100,000 a year, then your monthly debt payment should not exceed $3,000. The lower your DTI, the higher your chance for loan to be approved.
The Impact of Credit Rating
If the head side of the affordability coin is income, the tail side is a risk.
Most lenders have their own formula to determine the risk level of each prospective homebuyer. The formulas tend to vary among lenders but all of them would likely make use of the borrower’s credit score (See how to calculate your credit score).
The lower an applicant’s credit score is, the higher the interest he would most likely pay. Lenders also call this as the Annual Percentage Rate (APR) on a loan.
One helpful advice:
As you think of the kind of house you want in the future, work on your credit score now. And monitor your credit reports too. If there happen to be erroneous entries, it may take time to correct them. You don’t want lenders to disqualify you for your dream house because of something that’s no fault of yours. Here’s another thing that can offset negative entries in your credit report: it has to do with…
The down payment is the upfront amount that a homebuyer pays for the residence, in cash or other liquid assets.
If the homebuyer is purchasing a $100,000 home and can afford a down payment of 10%, he must put up $10,000. The lender will finance the remaining $90,000. Lenders will typically ask for a 20% down (this will exempt buyers from the private mortgage insurance) but some will settle for a lower down payment.
However, the more you can put down, the less financing you’ll need and you’ll paint a better credit image to the bank.
This chart shows that repeat buyers in the United States have consistently paid a higher down payment than new home owners. According to NAR research, new home owners paid at least 4% down payment, with the highest being 7% in 2018. Repeat buyers paid a down payment of at least 13%, and the highest payment was 16%.
Why's Down Payment Necessary?
Borrowing money is a risk for the lender and mortgages are one of the largest potential loans. A down payment allows you to share some of the risk with the lender. This is why lenders tend to look more favorably on applicants that can put a larger down payment towards a home purchase.
Another reason why you need a down payment for a mortgage is that it shows potential lenders that you are financially responsible enough to save sufficient money towards your new home. This is why lenders look very carefully at the source of your down payment. If they suspect you have taken out a loan for your down payment, it is a red flag on your application.
Finally, a down payment can provide you with a little protection in the event of a drop in house prices. Going into negative equity can be a bad financial situation, as you will end up owing more than the value of the property. For example, if you buy a home for $250,000 and put $50,000 down, you have a mortgage of $200,00. Now, if the property values suddenly drop and the home is now valued at $225,000, you could still sell the property and pay off the mortgage balance.
In a survey conducted by Point2 Homes in 2020 about the saving behavior of Millennials, 40% said they were saving less than 10% of their income on buying a home. In total, people saving below 20% of their income accounted for 72% of the respondents. Those saving over 50% of their income accounted for 7% of the respondents.
Do not forget to include the closing costs in your computations. It can be anywhere from 2 to 5 percent of the total purchase price depending on the location.
The good news:
Aside from the amount of the loan, the lender would also want to see how long would be the repayment term. Although a short-term mortgage may require a higher monthly payment, it may be less expensive overall.
Mortgage Types Affordability
For many new buyers, the type of mortgage they choose will significantly affect their budget. There are four major types of mortgages:
- Conventional. These are loans intended for sale to Fannie Mae or Freddie Mac, the giant mortgage investment companies. These loans usually require higher down payments and a more stringent underwriting standard than government agency-backed mortgages.
- The Federal Housing Administration-insured loans are really for first-time buyers and those with less-than-perfect credit histories.
- VA. These are loans provided by the U.S. Department of Veterans Affairs, mainly for military personnel in active duty. Retired military personnel can also avail.
- USDA. This is also called a Rural Development Loan. It serves homebuyers in rural and small towns where credit facilities may be scarce.
FHA loans allow a minimum down payment of 3.5% for applicants with FICO credit scores above 580. If the score is below 580, they will require a 10% minimum down payment. FHA rules are softer than the rules of conventional lenders like Fannie Mae and Freddie Mac. Sometimes, they will allow a 50% DTI or even higher if there are other compensating factors. Among them are having a lengthy stable employment record, a high credit score, some savings in the bank or other owned assets.
On the downside, FHA has materially raised its mortgage insurance fees so it may be more expensive than conventional loans month-on-month. This is assuming you have ready cash for a higher down payment.
For the qualified homebuyer, the VA and USDA loans offer the biggest loan with the lowest down payment. Down payment may be as low as zero and the underwriting guidelines are much easier to comply with, especially with the VA loan.
When Should You Hold off on Buying the House?
Although it may be tempting to buy that dream house as quickly as possible, there are some circumstances when it is a good idea to hold off on your plans. You shouldn’t rush into buying a property if you’re not financially stable, so if you don’t know how much you will be earning from one month to the next or are at imminent risk of losing your job.
It is also a good idea to hold off buying a home if you’re already struggling to meet your financial requirements. If you have a lot of debt that you are struggling to service, adding a mortgage into the mix is not a good idea. It is far better to take some time to try to pay down your debt, which will not only make your finances easier to manage, but also improve your debt to income ratio.
Finally, consider holding off on your plans if you have a bad credit rating. If you have the ability to take some time to build your credit before you buy your property, you could secure a better deal that will be more beneficial in the long term.
The Automated Underwriting
What most homebuyers are unaware of is that the success of their mortgage applications rests with two national computers. These computers flash tens of thousand of “yes”, “no” or “maybe” answers to lender inquiries daily. The first one is Loan Prospector (LP), which Freddie Mac owns and operates. The other is Desktop Underwriter (DU), which Fannie Mae runs.
When putting together, these two giant agencies supply the majority of the mortgage money in the U.S. Practically all banks use their online underwriting programs to make preliminary assessments of the feasibility of mortgage applications. This also includes loans intended for insurance backing by FHA, VA or USDA.
How It Works?
Your loan officer feeds your basic information into an LP or a DU. The underwriting software uses advanced statistical algorithms to determine if the proposed package deserves approval or rejection. It will take into consideration the credit reports, scores, income, assets, reserves, loan vs. property value, debt ratio, past mortgage vs. current application.
Automated underwriting actually increases your ability to acquire a home because it highlights bright spots in the application. These bright spots can counteract or outweigh the negative items in your application. For this reason, the underwriting process becomes more flexible than the customary strict set of rules. This explains why they sometimes approve 45% to 50% DTI.
Veteran loan officers have a way of getting your application approved through the DU or LP by adjusting the application “mix”. They can raise your credit score by asking you to reclassify some debt balances or finding ways to increase your eligible income.
One note of warning: Do not commit to a loan that will strain your monthly budget. This got many borrowers into trouble during the housing burst of 2007-2009.
How Much Money Should I Have Set Aside?
You don't want to deplete your savings account on a down payment because lenders want to know you'll have a cash reserve after you've purchased your property and moved in. Having some money in the bank after you purchase a home is an excellent method to avoid default and foreclosure. It's the cushion that assures mortgage lenders that you'll be able to pay your mortgage even if your financial condition changes.
It's a good idea to have enough money in your reserve to cover three months' worth of housing payments at the very least, but six months would be even better. That way, if you lose your job and need to find a new one, or if you decide to sell your home, you'll have plenty of time to do so without falling behind on your payments.
If you or your partner loses your work, your reserve might cover your mortgage payments, as well as insurance and property taxes. It provides wriggle room in the event of an emergency, which is always beneficial. You don't want to spend all of your savings on a home. Keeping extra cash on hand will assist keep you out of problems when it comes to unforeseen events and charges (roof repair, basement flooding, you name it!)
Now you have an idea of how the lender can determine how much mortgage you can afford. While having that amount is useful, do not exceed it. It is a good practice to apply your own standards. Just because a bank says you can borrow this much does it mean you should automatically borrow the maximum.
You are responsible for your own income and debt so use some common sense. For example, you may be thinking of your children’s college education or wedding in the future. The underwriting computers will not consider them in their computations but you should factor that on your own worksheet.
There are two ways to improve your DTI or Debt to Income ratio; either decrease your debt or increase your income. The latter could involve getting a raise, changing jobs or taking on a second job. The former will require taking some time to pay down your debt or consider debt restructuring. This will allow you to reduce your interest charges and pay down your debt more quickly.
While many people look at their maximum mortgage amounts, it is often a good idea to consider buying below your budget. Spending less will allow you to enjoy a little more financial flexibility. You won’t be at the maximum end of your affordability. So, if you do need to tighten your finances, you won’t be saddled with a hefty mortgage payment.
Another benefit of buying below your budget is that you could set up your mortgage with a shorter term. This will allow you to pay off your home more quickly and pay less in interest charges in the long term
If working out the 28/36 rule is a little too complicated, a good rule of thumb is that you can usually borrow up to 2.5 times your annual gross salary. However, your maximum mortgage will be calculated by your income to debt ratio, the down payment, your credit report and the purchase price of the home.
So, using this basic calculation, if you earn $50,000 a year, you could obtain a mortgage of up to $125,000
Yes, lenders will assess your debt to income ratio to determine if you can afford a new mortgage payment. Generally, it is a good idea to keep your overall monthly debt at less than 36%. This means that servicing your debt will take less than 36% of your gross monthly income. This ratio allows for you to cover a mortgage payment and your other expenses without putting yourself under excessive financial strain.
FHA loans have a low down payment, but this does mean that you will need to have a higher mortgage when you purchase your home. Again, it is a good idea to stick to the 28/36 rule to work out the maximum mortgage payment you can cover with your FHA loan.
Fortunately, there are calculators available that can help you to work out your expected monthly FHA mortgage payment.
The best way to work out how much you can afford with your salary is to use the 28/36 rule. As we covered earlier, this relates to having a mortgage payment of less than 28% of your pre tax monthly income and no more than 36% of your total debt.
So, to put this into perspective, if you earn $4,000 a month before tax, you can afford a mortgage payment of up to $1,120.
Obviously, you will need to factor into your calculations, any additional debt or expenses you need to service from your salary. This will impact how much you can afford to pay on your mortgage each month.