While it might be tempting to look at homes on the market where you want to live and decide that you can “afford” a place you want, purchasing a home requires more financial preparation than just an estimate of your monthly payment. A common rule of thumb is that you can afford to buy a home that costs two or three times your annual salary, but mortgage loan guidelines and your down payment are better measures of affordability. Lenders prefer that your housing payment be a maximum of 28 percent of gross monthly income.
Before you run payments on a mortgage calculator, you need to consider how much your down payment will be since that will lower your monthly housing payment. In addition, you should check your credit profile and credit scores, since your cost of borrowing will be lower if you have excellent credit. Consult a lender for a loan pre-approval before you start shopping for a home so you can stay within your approved price range.
Determine your comfort level
While a lender will walk you through financing options and pre-approve you for a specific loan amount, it’s best to decide for yourself how much you can comfortably afford before you visit a lender. Mortgage lenders’ standards are tougher than they were during the days of easy credit, but lenders also only see the payments you make that appear on your credit report when they estimate your budget. You should review your budget, including discretionary spending before you meet a lender.
If you have financial obligations or goals such as saving intensely for college tuition or for your retirement and want to continue that pattern after you become a homeowner, keep that in mind when determining an affordable housing payment. If you want to expand your family and plan to have one partner work less or will need to pay for child care, that should be part of your calculation. If your recreational activities include travel, skiing or golf, you’ll need to think about those expenses in the context of your budget.
You can also think about your comfort level with your current housing payment. If you’re renting, keep in mind that your new payment will include principal and interest on your loan, homeowner’s insurance and property taxes. You may also have a homeowner’s association fee and, if your down payment is less than 20 percent, you’ll pay mortgage insurance.
Qualifying for a mortgage loan
A lender can walk you through the process of applying for a loan and will check your credit, and verify your income and assets. Generally, lenders are restricted to approving loans with a maximum debt-to-income ratio of 41 to 43 percent, although there are some exceptions. For example, if you have excellent credit and significant liquid assets set aside for a large down payment, some lenders may approve you for a loan with a debt-to-income ratio up to 50 percent. The monthly debt included in the ratio is based on your total new housing payment and the minimum monthly payments on outstanding debt such as credit card balances, student loans, car payments, personal loans, alimony or child support.
A higher credit score of 740 or above can improve your ability to obtain a loan approval since you are considered less of a credit risk. In addition, borrowers with a high credit score usually qualify for a lower interest rate, which reduces the debt-to-income ratio.
If you’re on the border of a loan approval, your lender can work with you to find ways to improve your credit or to reduce your debt-to-income ratio. For example, paying down a credit card balance can boost your credit score and lower your debt. Increasing the size of your down payment reduces the amount you need to borrow, therefore lowering your monthly payments, but also lowers your loan-to-value, which in turn may lower your interest rate.
A variety of loan programs such as Fannie Mae, Freddie Mac, FHA and VA loans, as well as “Portfolio Loans” from community banks and credit unions are available to make financing your home purchase easier. Shopping around with more than one lender will yield more loan options and increase your level of knowledge about home financing.