How Do We Calculate Your Mortgage Affordability?
|Available Mortgage Limits||Min||Max|
|Affordable Debt Payments||$123||$ 123|
|Total Debt Payments Excluding Mtg||$123||$123|
|Available Income for Mortgage Payment||$123||$123|
Recommended Max Prise
Down Payment (%)
Down payments less then 20% may require private mortgage insurance (PMI)
How Do We Calculate Your Mortgage Affordability?
Many first-time homeowners may have paid rent for years leading up to purchasing their first home. However, your rent amount does not laterally translate into how much you can afford on your mortgage.
How much house you can afford can be viewed from two perspectives: the amount you think you can afford to pay in your monthly payment, including ancillary expenses such as insurance and taxes; and, the amount lenders think you can afford to spend on housing.
Information Considered in the Affordability Calculator
Annual Household Income
The first factor of mortgage affordability is your income or the amount you earn. Your income may include salary, wages, tips, and commissions, calculated before consideration of income taxes. If you are taking out a loan with a co-borrower, such as your spouse, you should input your combined income into the calculator.
Monthly Debts and Household Expenses
Monthly debts and household expenses address the amount of monthly income that is already accounted for, meaning it is the amount of your monthly income that is not available to service mortgage payments. Monthly debts include all recurring debt payments such as student loans, auto loans, and minimum credit card payments. Household expenses account for items like insurance policy payments, utilities, telephone and cellphone bills, subscriptions, and groceries. You may also want to consider including any amount you set aside for savings to get a more accurate depiction of what you can truly afford for your mortgage payment.
The two most common loan types are fixed-rate and adjustable rate mortgages (ARM).
Fixed Rate Mortgages
Fixed-rate home loans are the easiest to calculate. Your interest rate is pre-determined and does not change for the entire loan term. As a result, your monthly mortgage payment also does not change.
There are usually two types of fixed-rate mortgages: 30-year fixed and 15-year fixed. A 30-year fixed mortgage is best option for those who favor a lower monthly payment. With a 15-year fixed mortgage, you are out of debt quicker and pay less interest overall but have a higher monthly payment.
Adjustable Rate Mortgages
Adjustable rate mortgages, also known as variable rate loans, customarily have a lower interest rate for a set period of time during the introductory period. Afterward, the interest rate varies depending on the market for the rest of the loan term.
An ARM is ordinarily expressed using two numbers, such as 3/1, 5/1, or 10/1. The first number is the number of years that your interest rate is fixed. The second figure is how frequently adjustments can be made to the interest rate after the introductory period has expired.
For example, a 3/1 ARM translates to 3 years at a locked interest rate and then varies every year for the duration of the loan. One type of ARM does not follow this rule. The 5/6 ARM is an exception, which has a set rate for five years and then changes every six months.
Your loan term is the life of the loan. The loan term determines how many much time you have to pay off your mortgage in its entirety. In general, a longer loan term translates to lower monthly payments because you are spreading out the total cost of the home over a longer period of time. The downside is you will pay interest for the entire loan period, resulting in more interest paid overall.
On the other hand, a shorter loan term usually results in higher monthly payments. The benefit is you will pay off the loan faster, resulting in fewer interest payments and less interest over the life of the loan.
Loan Interest Rate
Your credit score heavily influences your loan’s interest rate. Although we do not factor credit scores into the calculator (i.e., how high or low credit score is), it typically goes hand in hand with how high or low your interest rate is. In general, the higher the credit score, the lower the interest rate for most loans.
Saving for a larger down payment and increasing your credit score can help you qualify for a lower interest rate. Lenders set the interest rate on your loan using a variety of factors, so be sure to shop around before settling on a lender. It may also be worth checking your credit score and resolving any issues with your credit history before approaching lenders.
The golden down payment number is 20 percent of the purchasing price. For a conventional mortgage, a 20 percent down payment usually eliminates the need for private mortgage insurance or PMI. Lenders require PMI until the homeowner has at least 20 percent equity.
Similarly, for an FHA loan, a 20 percent down payment would also eliminate the need for a mortgage insurance premium or MIP. If your initial loan-to-value ratio is 90 percent, you will pay MIP for 11 years. Otherwise, you will pay MIP for the entire loan term.
Although some lenders may approve a lower down payment, sometimes as little as 3.5 percent, 20 percent still stands as the recommended amount to avoid mortgage insurance.
Annual Property Tax
Every homeowner is responsible for property taxes, which is paid either once or twice a year. The tax rate varies on the location of your home and is multiplied by your home’s assessed value. For example, the property tax rate in Saint Clair, Alabama, is 0.336 percent of the assessed value, whereas the property tax rate in Los Angeles, California, is 0.793 percent of the assessed value. Therefore, if you have a $500,000 home in Los Angeles, your annual property tax would be $3,965 or 0.793 percent times $500,000.
The national average property tax rate is 1.211 percent.
You may see homeowners’ insurance as well as mortgage insurance included in your monthly mortgage payment.
Homeowners’ insurance is a class of insurance that protects your home and belongings. Your homeowners’ insurance will reimburse you for damages to the physical structure of the house, your personal belongings, as well as accidental injury that may occur on your property.
Lenders may require private mortgage insurance or PMI on conventional loans if your down payment is less than 20 percent of the purchase price. Alternatively, lenders may require mortgage insurance premiums or MIP on FHA loans if your down payment is less than 20 percent.
Mortgage insurance serves to protect the lender if the borrower defaults on the loan.
HOA or a homeowners’ association charges a monthly fee to all homeowners within the community’s jurisdiction. This organization serves to make and enforce rules for properties in its community. The dues can pay for expenses within your home and outside your home, such as your water bill, exterior maintenance, or trash pick-up. It may also go towards common property expenses for your community.
If you purchase property within an HOA’s jurisdiction, you automatically become a member of the HOA and are obligated to pay the HOA dues. To avoid these fees, be sure to choose a home that is not a part of an HOA community. Or, at the very least, be sure to factor in these payments when determining how much home you can afford.
Monthly Mortgage Payment
Your monthly mortgage payment is comprised of the loan’s principal and interest. Depending on the lender, you may be required to have an impound account or escrow account. Along with your mortgage payment, you would also pay for your homeowners’ insurance, private mortgage insurance, other required insurance, such as flood insurance, and property taxes.
These monthly payments are deposited into your impound account or held in escrow until the annual bill is due.
You may also consider adding 1 percent of your property’s value into a savings account to budget for home maintenance costs and future repairs.
Most financial experts agree that your debt-to-income ratio should not exceed 36 percent of your gross (pre-tax) income. Banks calculate your debt-to-income ratio by dividing all of your monthly debts by your monthly income. Your monthly debt includes mortgage or rent payments, auto loans, student loans, other loans or lines of credit, minimum credit card payments, and child support or alimony.
Some home loans allow for higher debt-to-income or DTI ratios. For example, FHA loans permit up to 45 percent, while VA and USDA loans allow up to 41 percent.
While these loans may approve a higher DTI ratio, it is not always recommended. A mortgage payment may be categorized as affordable, stretching, or aggressive. A lower DTI may be more affordable and fit more comfortably in your budget, allowing you to save for your family’s emergency fund or necessary household repairs. On the other hand, borrowing at the maximum DTI ratio may be too aggressive and stretch your budget too thin.
You should always assess your financial situation and determine a monthly mortgage limit that you feel comfortable with before making an offer on a home and signing a purchase agreement.
The 28/36 Rule
Most lenders follow the 28/36 rule of thumb during the underwriting process. Lenders generally recommend that up to 28 percent of a household’s gross monthly income can be spent on homeowner expenses, including mortgage payments, HOA fees, home insurance, and property taxes with a recommended debt-to-income ratio of 36 percent.
If an individual exceeds these ratios, it is more difficult for the borrower to support his or her debt load. As a result, the borrower is more likely to default. If your debt ratios exceed the 28/36 rule, your home loan application may be denied, or you may receive less than favorable loan terms, such as a higher interest rate. Fortunately, some lenders may be a bit flexible with this rule if you have a stellar credit score.
For example, let's say a household has a monthly income of $6,000. The 28/36 rules suggests 28 percent of $6,000 (or 0.28 times 6,000) or $1,680 can go towards your monthly home expenses. Similarly, the rule implies 36 percent of $6,000 (0.36 times 6,000) or $2,160 can be allocated to cover your debt payments, including mortgage or rent payments, auto loans, student loans, other loans or lines of credit, minimum credit card payments, and child support or alimony.
As noted above, some lenders may permit your debt-to-income ratio to exceed 36 percent and stretch as high as 45 percent.
While pre-approval does not guarantee a loan, it provides a reliable indication of what your loan terms will look like. A pre-approval letter is a useful tool if you would like to know how much home you can afford and what the loan will cost you. Of course, pre-approval does not involve a thorough underwriting process.
Another benefit of pre-approval is real estate agents and sellers will view you as a more serious buyer with more room to negotiate once you find your dream home. After pre-approval, you will need to undergo a formal evaluation by a loan underwriter to receive your official loan estimate.