How Much Home Can I Afford?

Dated: June 4 2024

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Plenty of online mortgage calculators help you figure out how much you can afford to spend on a home. With some quick math, you can get an idea, but there’s a lot more information you need to get the real picture of affordable homes for your household’s needs. 

Assuming you’re just beginning the homebuying process, you may be browsing the internet looking at interest rates and home listing sites to “get an idea” before contacting a lender or a real estate agent. You’ll be far better prepared if you “qualify” yourself for a loan by answering all the questions a mortgage lender would ask.

USAA.com recommends figuring out your starting price range by analyzing your finances. You must outline a monthly budget. Most lenders like to keep housing costs between 25% to 36% of your take-home pay so you’re less likely to experience financial pressures and default on an affordable payment. Housing costs include your mortgage payment, private mortgage insurance and homeowner association fees, property taxes, and homeowner’s insurance. Bundling all or most of these expenses into an escrow account managed by the lender should make it easier to estimate your monthly costs and to be sure all housing obligations are being paid on time.

Lenders get the money to lend to homebuyers from a uniquely American system. The Federal Housing Administration insures loans made by FHA-approved lenders. To get a low-cost FHA loan requiring only a 3.5% down payment and a credit score of at least 580, all borrowers are required to buy mortgage insurance, so in case the borrower defaults, the insurance will pay the lender the remaining balance of the loan. The FHA calculates mortgage insurance premiums (MIP) at 0.55% of the loan balance. If you have a loan balance of $200,000, you’ll pay $1,100 annually for MIP.

The Veterans Administration insures loans for qualifying active and former military personnel. You’ll need a Certificate of Eligibility to present to your lender who will follow other low-cost mortgage solutions for you, some with zero percent down.

Fannie Mae and Freddie Mac are government-sponsored entities that buy existing loans from lenders and packages them into mortgage-backed securities. To qualify, you’ll need up to 20% down and a credit score of 620. Lenders call these conventional loans. If you put down less than 20%, you must qualify for the loan with private mortgage insurance (PMI). Unlike FHA loans, conventional loans with PMI can be eliminated once the equity of your home surpasses 20%.

It may surprise you to learn that the mortgage interest rates you see advertised online seem lower than you’d expect, which is another reason why online calculators don’t tell the whole story. These idealized rates are based on high credit scores, 20% down payments, and benchmark 30-year fixed-rate mortgage terms. In reality, mortgage interest rates can vary for borrowers based on their city’s location, personal credit scores, the cost of the home they want to buy, the size of their down payment, and their loan-to-debt ratio. 

Your credit history is crucial in determining the lender’s approval process. Lenders look at your outstanding income-to-debt ratio, on-time payment record, and how you use credit. Lenders want to avoid defaults on loans, so they want to make sure you’re managing your debt at no more than 36% of your gross income. Are you paying off student loans and car loans? Do you pay off credit cards every month or max out your available credit to make only the minimum payments required? Your credit scores will reflect your use of credit and the number can impact your mortgage interest rate.

You may receive a pre-qualification from your lender that will tell you how much you can spend on a home and what your interest rate is likely to be. But the prequalification is only going to be based on a snapshot of your finances—your credit score. Once you’ve selected a home, your loan will go through the underwriting process which dives deeply into your repayment history and credit use. If the underwriter finds a derogatory in your credit history, such as a lien or credit card in collections, they will tell the lender that the loan won’t be approved until the derogatory is paid in full.

There are other costs associated with buying a home that will affect how much you want to spend and how much the lender will give you, such as HOA fees, homeowners’ insurance, and property taxes. HOA fees vary from a few hundred dollars a month to well into four figures and homeowners’ insurance is also several hundred dollars a month—but the biggest variable is property taxes. Most data about a home’s history is transparent so you’ll be able to go online and see how the previous owner has been assessed by their taxing authority. But keep in mind that the longer the home seller has owned the home, the lower their tax bill will be. Most communities set property tax rates based on the purchase price of the home, with caps on how much those rates can increase annually. The seller may have a lower tax rate because the home is a homestead, and the rate will be even lower if the seller is over 65. Your tax bill will reset based on what you paid for the home at the next assessment.

So, when you’re evaluating the what-ifs of how much home you can afford, calibrate your costs by doing the following.

1.    Redo your monthly budget to pay down debt as quickly as you can afford.

2.    Get your credit history from all three credit reporting bureaus at Annualcreditreport.com. Look for mistakes and derogatories. Use the lowest score for your what-if scenarios. 

3.    Determine where you’ll get your down payment and how much you can afford to put down. Some loan programs allow gifts from parents or friends, or you may tap into your savings or 401K.

4.    Decide which loan product is best for you. Adjustable-rate mortgages are less than fixed rates, but they can adjust to much higher market rates later.

If you get prequalified for a certain amount, that doesn’t mean you should spend that much for a home. You want your home to be comfortably affordable. Living at the top of your means is stressful. It’s far better to buy a less expensive home and be able to afford to have your first child, take vacations, buy that new car, get your master’s degree, or pursue other life goals.

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