If you’re looking to see how much house you can afford, you know that want to get the most bang for your buck. This is especially true when it comes to buying a home. You’ll be tied to a mortgage for 15 to 30 years (or more!), so it’s vital that you carefully consider how much home you can really afford. Plan your finances in advance, and should your income change, it’ll prevent you from having to make a heartbreaking decision in the future.
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How much will banks lend me?
The first thing that potential lenders will look at before they decide to issue you a loan is your debt-to-income ratio (DTI). Your DTI ratio is composed of two parts: your total monthly financial obligations, and the total monthly income of everyone who will be signed onto the mortgage.
Your monthly financial obligations include every recurring payment you make — your rent or housing payment, payments you make on credit card debt or auto loans, student loan payments, alimony or child support, etc. To calculate your DTI, add up your household’s total monthly pre-tax income, divide your monthly financial obligations by your total pre-tax income and multiply your result by 100.
Most banks and lenders use what’s called the “28-36 rule” when it comes to determining how much house you can afford. This rule states that you should not spend more than 28% of your monthly income on housing, and your DTI should not be greater than 36%. While the 28-36 rule is generally used as a flexible rule-of-thumb, you should aim to pay down debts so that your DTI is as low as possible.
Lenders see a high DTI as a warning sign that you may be more likely to fall behind on your bills should your financial situation change, and thus may be more hesitant to issue you a loan. A low DTI and a high income will position you for the highest possible mortgage approval. A mortgage calculator can calculate how much home you can reasonably afford using your income and monthly expenses.
Your income and debts are far from the only factors that affect how much money a mortgage lender will be willing to issue to you. Other factors include:
You’ve heard the famous saying: “Real estate is all about location, location, location!” Hotspots for real estate, including metropolitan areas and gated communities, charge a premium for their properties — meaning that you won’t be able to stretch your dollar as far in these locations. These premium areas also come with a number of hidden fees as well, including higher property taxes and homeowner’s association dues. Some of the most expensive cities to live in include San Francisco, New York City and Los Angeles.
2. Your credit score
Your credit score is a signal that lenders can use to sum up how you handle your finances. If you have a high credit score, it tells lenders that you rarely miss payments, you don’t take on more debt than you can afford, and you manage your money well. On the opposite end of the spectrum, if you have a low credit score, lenders may hesitate when approving you for a mortgage or loan.
3. The type of housing you’re looking for
Each type of housing comes with unique costs and fees. If you are looking to purchase a condo, you must consider the costs of maintenance and security fees. If you’re applying for a loan to purchase and own your own home, don’t forget to consider the costs of any necessary repairs and utilities that you’ll be responsible for.
4. Your down payment
A larger down payment can offset the monthly costs of a mortgage, allowing you to purchase a better or bigger home. You should aim to save up a down payment of at least 20% of the cost of the highest-priced home you can reasonably afford, otherwise, you may be subject to additional fees.
5. Your employment status
How stable is your job? Would you and your spouse move if a great opportunity came along in a different city? Lenders may ask about your employment history to ensure that you are in a comfortable place to make a major investment tying you to the area. A buyer who has been in his or her position for years may qualify for a larger loan because a stable job indicates that he or she is less likely to see a drop in income that would affect his or her ability to pay the mortgage.
6. Your age.
Though lenders aren’t supposed to consider your age when applying for a mortgage, many are reluctant to issue loans to older buyers. Lenders need to know that you’ll have the income needed to make regular payments on your property. Men and women over the age of 65 and those who are retired pose a massive risk to lenders and have a more difficult time securing a loan.
7. The housing market.
The economy goes in cycles — sometimes the market is more favorable to buyers, and sometimes housing prices spike and sellers are in control. The housing markets of individual cities can also go through their own economic cycles, and even innocuous factors like the season can change the swing of the housing market.
8. Home insurance costs
Homeowners insurance is a special type of coverage that protects you in the event of a fire, burglary or a storm. Many mortgage providers require that homeowners have insurance before they will sign off on a loan.
9. Property maintenance
Consider the costs of home improvements you’d like to make before you sign off on a mortgage, and keep a savings account for emergencies, such as roof repair or window replacement.
If you’ve been renting a home until now, you may have had some of your utility costs covered by your landlord. When you own a home, you will be totally responsible for covering all utilities: monthly water, electricity, gas, and cable costs are just the beginning.
Strategies to improve your DTI ratio
1. Reduce your debt
Your DTI ratio is one of the first things that banks will consider when applying for a loan. Reduce the amount you owe, and that can help improve your chances of securing a larger loan. Paying more than the minimum monthly payments and consulting with a debt consolidation company are two ways that you can work to reduce the amount of money that you owe and lower your DTI ratio.
2. Improve your credit score
A great credit score shows lenders that you’re responsible and have the means to pay your bills. Regularly making on-time payments on your accounts, lowering the amount of credit you use, and securing an increase in your credit line are all steps that you can take to improve your score and make you a more appealing applicant. If you’re interested in learning more about how your credit score is calculated, check out this primer course on how FICO determines your score:
3. Save for a bigger down payment
A down payment of over 20 percent will help to limit monthly costs and reduces the amount of money you’ll need to take out from your lender.
It’s important to remember that life offers unexpected changes. You or your spouse may lose your job, deal with an unplanned medical bill or become the victim of a crime. Just because a lender is willing to loan you $XXX,XXX for your mortgage doesn’t mean you should necessarily take the maximum amount. You understand your personal finances better than anyone else — don’t be afraid to spend plenty of time alone with your budgeting tools before you make a major investment of any kind.