Purchasing real estate with a mortgage is often the largest personal investment most people make. How much you can afford to borrow depends on a number of factors, not just what a bank is willing to lend you. You need to evaluate not only your finances, but also your preferences and priorities.
Here is everything you need to consider to determine how much you can really afford.
- The general rule is that you can afford a mortgage that is 2x to 2.5x your gross income.
- Total monthly mortgage payments are typically made up of four components: principal, interest, taxes, and insurance (collectively known as PITI).
- Your front-end ratio is the percentage of your annual gross income that goes toward paying your mortgage, and in general, it should not exceed 28%.
- Your back-end ratio is the percentage of your annual gross income that goes toward paying your debts, and in general, it should not exceed 36%.
Determining What Is an Affordable Mortgage
Generally speaking, most prospective homeowners can afford to finance a property that costs between two and two-and-a-half times their annual gross income. Under this formula, a person earning $100,000 per year can only afford a mortgage of $200,000 to $250,000. However, this calculation is only a general guideline.
Ultimately, when deciding on a property, you need to consider several additional factors. First, it's a good idea to have some understanding of what your lender thinks you can afford (and how it arrived at that estimation). Second, you need to have some personal introspection and figure out what type of home you are willing to live in, if you plan on living in the home for a long time, and what other types of consumption you are willing to forgo—or not—to live in your home.
While real estate has traditionally been considered a safe long-term investment, recessions and other disasters (like the COVID-19 pandemic) can test that theory—and make would-be homeowners think twice.
While each mortgage lender maintains its own criteria for affordability, your ability to purchase a home (and the size and terms of the loan you will be offered) will always depend largely on the following factors.
This is the level of income a prospective home-buyer makes before taking out taxes and other obligations. This is generally deemed to be your base salary plus any bonus income and can include part-time earnings, self-employment earnings, Social Security benefits, disability, alimony, and child support.
Gross income plays a key part in determining the front-end ratio, also known as the mortgage-to-income ratio. This ratio is the percentage of your yearly gross income that can be dedicated toward paying your mortgage each month. The total amount of money that makes up your monthly mortgage payment consists of four components, known as PITI: principal, interest, taxes, and insurance (both property insurance and private mortgage insurance, if required by your mortgage).
A good rule of thumb is that the front-end ratio based on PITI should not exceed 28% of your gross income. However, many lenders let borrowers exceed 30%, and some even let borrowers exceed 40%.
Also known as the debt-to-income ratio (DTI), it calculates the percentage of your gross income required to cover your debts. Debts include credit card payments, child support, and other outstanding loans (auto, student, etc.).
In other words, if you pay $2,000 each month in debt services and you make $4,000 each month, your ratio is 50%—half of your monthly income is used to pay the debt.
However, a 50% debt-to-income ratio isn’t going to get you that dream home. Most lenders recommend that your DTI not exceed 36% of your gross income. To calculate your maximum monthly debt based on this ratio, multiply your gross income by 0.36 and divide by 12. For example, if you earn $100,000 per year, your maximum monthly debt services should not exceed $3,000. The lower the DTI ratio, the better.
Mortgage lending discrimination is illegal. If you think you've been discriminated against based on race, religion, sex, marital status, use of public assistance, national origin, disability, or age, there are steps you can take. One such step is to file a report to the Consumer Financial Protection Bureau or with the U.S. Department of Housing and Urban Development (HUD).
Your Credit Score
If one side of the affordability coin is income, then the other side is risk. Mortgage lenders have developed a formula to determine the level of risk of a prospective home-buyer. The formula varies but is generally determined by using the applicant’s credit score. Applicants with a low credit score can expect to pay a higher rate of interest, also referred to as an annual percentage rate (APR), on their loan.
If you know you're going to be looking for a home in the future, work on your credit score now. Be sure to keep a close eye on your reports. If there are inaccurate entries, it will take time to get them removed, and you don’t want to miss out on that dream home because of something that is not your fault.
How to Calculate a Down Payment
The down payment is the amount that the buyer can afford to pay out-of-pocket for the residence, using cash or liquid assets. A down payment of at least 20% of a home’s purchase price is typically demanded by lenders, but many let buyers purchase a home with significantly smaller percentages.
Obviously, the more you can put down, the less financing you’ll need, and the better you look to the bank.
For example, if a prospective home-buyer can afford to pay 10% on a $100,000 home, the down payment is $10,000, which means the homeowner must finance $90,000.
In addition to the amount of financing, lenders also want to know the number of years for which the mortgage loan is needed. A short-term mortgage has higher monthly payments but is likely less expensive over the duration of the loan.
Homebuyers need to come up with a 20% down payment to avoid paying private mortgage insurance.
How Lenders Decide
Many different factors go into the mortgage lender’s decision on home-buyer affordability, but they basically boil down to income, debt, assets, and liabilities. Sometimes we think our mortgage applications are judged by a person who uses a gut feeling rather than objective criteria, but in fact, even if your mortgage lender was having a bad day, you can rest assured that much of the process is formulaic.
A lender wants to know how much income an applicant makes, how many demands there are on that income, and the potential for both in the future—in short, anything that could jeopardize its ability to get paid back. Income, down payment, and monthly expenses are generally base qualifiers for financing, while credit history and score determine the rate of interest on the financing itself.
Personal Considerations for Home-buyers
A lender could tell you that you can afford a huge estate, but can you really? Remember, the lender’s criteria look largely at your gross pay and other debts. The problem with using gross pay is simple: You are factoring in as much as 30% of your paycheck—but what about taxes, FICA deductions, and health insurance premiums? Even if you get a refund on your tax return, that doesn’t help you now—and how much will you really get back?
That’s why some financial experts feel it’s more realistic to think in terms of your net income (aka take-home pay) and that you shouldn’t use any more than 25% of your net income on your mortgage payment. Otherwise, while you might be literally able to pay the mortgage monthly, you could end up “house poor.”
The costs of paying for and maintaining your home could take up such a large percentage of your income—far and above the nominal front-end ratio—that you won’t have enough money left to cover other discretionary expenses or outstanding debts or to save for retirement or even a rainy day. The decision of whether or not to be house poor is largely a matter of personal choice; getting approved for a mortgage doesn’t mean you can actually afford the payments.
Be honest about the level of financial risk that you are comfortable living with.
In addition to the lender’s criteria, consider the following issues when contemplating your ability to pay a mortgage:
Are you relying on two incomes just to pay the bills? Is your job stable? Can you easily find another position that pays the same, or better, wages if you should lose your current job? If meeting your monthly budget depends on every dime you earn, even a small reduction can be a disaster.
The calculation of your back-end ratio will include most of your current debt expenses, but what about other expenses you haven’t generated yet? Will you have kids who go to college someday? Do you have plans to buy a new car, truck, or boat? Does your family enjoy a yearly vacation?
Are you willing to change your lifestyle to get the house you want? If fewer trips to the mall and a little tightening of the budget don’t bother you, applying a higher back-end ratio might work out fine. If you can’t make any adjustments—or you already have considerable credit card account balances—you might want to play it safe and take a more conservative approach in your house hunting.
No two people have the same personality, regardless of their income. Some people can sleep soundly at night knowing that they owe $5,000 per month for the next 30 years, while others fret over a payment half that size. The prospect of refinancing the house in order to afford payments on a new car would drive some people crazy while not worrying others at all.
Costs Beyond the Mortgage
While the mortgage is certainly the largest financial responsibility of homeownership, there are a host of additional expenses, some of which don’t go away even after the mortgage is paid off. Smart shoppers would do well to keep the following items in mind:
Even if you build a new home, it won’t stay new forever, nor will those expensive major appliances, such as stoves, dishwashers, and refrigerators. The same applies to the home’s roof, furnace, driveway, carpet, and even the paint on the walls. If you are house poor when you take on that first mortgage payment, you could find yourself in a difficult situation if your finances haven’t improved by the time your home is in need of major repairs.
Heat, insurance, electricity, water, sewage, trash removal, cable television, and telephone services all cost money. These expenses are not included in the front-end ratio, nor are they calculated in the back-end ratio. Nevertheless, they are unavoidable for most homeowners.
Many condominiums and coops, as well as certain gated neighborhoods or planned communities assess monthly or yearly association fees. Sometimes these fees are less than $100 per year; other times they are several hundred dollars per month. In some communities they include lawn maintenance, snow removal, a community pool, and other services.
Some fees are only used for the administration costs of running the community. It’s important to remember that while an increasing number of lenders include association fees in the front-end ratio, these fees are likely to increase over time.
Furniture and Decor
Drive through almost any community of new homes after the sun goes down and you’re likely to notice some interior lights illuminating vast, empty rooms that you can see only because those big, beautiful houses don’t have any window coverings. This isn’t the latest decorating trend. It’s the result of a family that spent all its money on the house and now can’t afford curtains or furniture.
Before you buy a new house, take a good look at the number of rooms that will need to be furnished and the number of windows that will require covering.
The Bottom Line
The cost of a home is the single largest personal expense most people will ever face. Prior to taking on such an enormous debt, take the time to do the math. After you run the numbers, consider your personal situation and think about your lifestyle—not just now but into the next decade or two.
The dream home may be everything you’ve wanted at a great price now, but is it worth overextending yourself and your family? Will you be mortgaging not only your house but your entire lives as well? A lender helps you buy a home, but the person who should decide if you can actually afford it is you.