What Can I Afford?

How Much House Can I Afford?

How much house you can afford depends on two things: (1) your down payment and (2) the amount you are able to borrow. Let’s consider the down payment first.

Down Payment

First, you need to determine the amount of cash you have available to purchase your home. Cash means either cash in the bank or cash that can be raised from the sale of investments or other real estate. It does not mean money borrowed from third parties (including your business). It does include cash gifted to you by relatives.

From this amount you must deduct several unavoidable expenses that include: (1) mortgage origination fees, (2) real estate appraisal fees, (3) home inspection fees, (4) attorney’s fees, (5) moving expenses, and (6) utility setup charges. Deduct these amounts from your total cash to get the amount available for a down payment.

It is important that you make good estimates for items (1) through (6) above. If you are unable to do this yourself, you should work with an experienced Realtor who can help you. There’s no cost for working with a Realtor because the seller will pay their commission. Read Do I Need a Realtor? for more about finding a good Realtor who can assist you.

(You’ll notice that we did not include any money for furnishing your new home. If you plan to spend money for furniture, decorating or landscaping, you must also deduct those amounts from your total available cash. This will further reduce the cash you have remaining for a down payment.)

To qualify for a conventional loan, your lender will likely require a down payment ranging from 10% to 20% of the purchase price of the house. Under the current conditions of the credit market, most home buyers will need a down payment of 20% to purchase a home meaning the the loan will constitute 80% of the purchase price. This is the loan-to-value ratio or LTV.

Lenders publish their available loan terms including interest rates and required down payment. It’s easy to find mortgage loan quotes for lenders in your area either on the internet or in print newspapers. All quotes are based on the assumption that your credit is acceptable which brings us to the next step.

Mortgage Loan Amount

Conventional and FHA loans are the most common types of mortgages available to home buyers today. Conventional loans are purchased by Fannie Mae and Freddie Mac (the two largest government-sponsored lenders) and follow guidelines set by them. FHA (Federal Housing Authority) is a government program run by the U.S. Department of Housing and Urban Development that insures loans approved by lenders using this program.

FHA loans, often sought by first-time home buyers, typically allow lower down payments and weaker credit history than do conventional loans. While the three agencies provide different types of loans, what they look for in a potential borrower is similar. Here’s how lenders evaluate prospective borrowers:

Credit History

Mortgage lenders look for borrowers with a good pattern of paying their obligations. Each of the three major credit bureaus provides a credit score that is based on the consumer’s credit history. Mortgage lenders analyze the credit reports from all three credit bureaus and the corresponding credit scores. Lenders will use the middle of the three, so if the scores are 664, 678, and 671, the 671 score is used to qualify. The higher the credit scores the better the rate and terms allowed.

Conventional loans currently require a credit score of 680 to 720 (depending on other factors such as those described below) while FHA loans only require a minimum credit score of 580. Many factors affect credit scores, but the most important is the timely payment of loans. Items like bankruptcy and foreclosure can automatically disqualify a borrower from obtaining a loan for years.

Income Requirements

Lenders require that borrowers have stable, consistent income. Lenders evaluate the borrower’s proposed DTI (debt-to-income ratio, or the amount of all monthly debt in relation to gross income earned). Obviously, this means that you can improve your DTI by retiring existing debt such as auto loans or student loans. For conventional loans, lenders look for a maximum DTI ratio of 33 percent (total debt cannot exceed 33% of gross income). FHA loans allow a higher DTI, generally not over 55%. Sometimes lenders exceed this amount with other compensating factors like excellent credit or a large down payment.

Also note that a two-year work history is usually required in the same job and field. Newly self-employed borrowers usually must wait until two years of self-employment tax returns are available before obtaining a new mortgage.

Savings Requirements

Borrowers who show a history of saving money are considered less risky than those who do not. While a full 20 percent down payment is not always required, there are very few zero down payment loans available other than VA loans for veterans. Most conventional loans require a down payment of 10 to 20 percent while FHA loans do as low as a 3.5 or 5 percent down payment. Down payments of 10% or less require that borrowers obtain private mortgage insurance or PMI (insurance that protects the lender against default) which is an additional monthly charge.

Depending on the loan program, all or part of the down payment can be a gift from relatives. But it must be a gift, not a loan, and a letter confirming that it is a gift is required. Lenders prefer, although do not always require, that the borrower have at least two months of debt payments in reserve when a loan is approved.

Property Value

A real estate appraisal is required on virtually every mortgage loan. A licensed appraiser uses recent sales in the property’s neighborhood to estimate a value for the home. Appraisers use at least three recent sales (called “comps” or “comparables”) to determine value in an appraisal report. They should be close in style and desirability to the subject property and the property’s neighborhood. For example, appraisers cannot use four-bedroom houses to determine a value for a two-bedroom home or use other properties that are not similar. Lenders want confirmation the home is in good condition and has a value equal to or higher than the purchase price.

What Can I Afford?

Apart from the market value of the house itself, there are three basic factors under your control that determine the amount of house you can afford: (1) your credit score, (2) your available down payment, and (3) your DTI ratio (before-tax income versus total debt). And since every lender will evaluate borrowers somewhat differently, you can see there’s uncertainty in the loan approval process. This is why getting pre-qualified for a loan is important and greatly improves your credentials as a buyer. By getting pre-qualified, you’ll know the top price range of homes you can afford.

But just because you can do something doesn’t mean you should do it. When you know what your debt service payment would be (debt service includes interest, principal, taxes and insurance), you can then make an informed decision whether you want to purchase the largest possible home or have less debt and a smaller home. There are plenty of good reasons for either decision.