Many prospective homeowners applying for a mortgage tend to have two concerns before they agree to sign: How much interest will I end up paying, and can I afford the monthly payments? Investopedia's free, online mortgage calculator helps you calculate your monthly mortgage payments and make the right financial decisions when buying a house.
Mortgage Calculator (monthly payments)
Investopedia's mortgage calculator runs complex formulas to account for your principal, interest rate, and the duration of your loan to determine how much you can expect to pay each month. Calculating your possible monthly payments is just the first step, however; to know whether buying a home is the right financial decision for you, read our essential homebuyer's fact sheet below to know exactly where you stand when taking out a mortgage.
"How Much House Can I Afford?" A Tutorial and Checklist
A mortgage calculator can help you see if you can buy a home. But deciding if you can actually afford a home is more complex.
Generally speaking, most prospective homeowners can afford to mortgage a property that costs between 2 and 2.5 times their gross income.
Under this formula, a person earning $100,000 per year can afford a mortgage between $200,000 and $250,000 – but this calculation is only a general guideline.
First, it's a good idea to have an understanding of what your lender thinks you can afford. To gain a precise idea of what size mortgage their clients can handle, lenders use formulas that are much more complex and thorough.
Second, you need to determine some personal criteria by evaluating not only your finances but also your lifestyle preferences.
Purchasing a four-bedroom home with a pool may fulfill some of your goals and dreams; however, it could leave you "house poor" – that is, without enough money to maintain your too-expensive house and pay for any other expenses.
As grim as that sounds, many people choose to be house poor because they believe ultimately their income will increase as a result of raises and promotions, making that expensive mortgage a smaller and smaller percentage of their monthly expenses.
In order to avoid being house poor consider the following issues before taking on a sizeable mortgage:
When contemplating your ability to pay a mortgage, ask yourself the following questions: Are you relying on two incomes just to pay the bills? Is your job stable? Could you easily find a job that would enable you to make payments if you lost your job?
Are you willing to change your lifestyle to get the house you want? Will you be able to realistically transform your lifestyle to save the money required to pay for an expensive mortgage?
Regardless of your income, will having a big mortgage keep you up at night?
Mortgage Lenders' Criteria
From a bank's perspective, your ability to purchase a home depends largely on the following factors:
The front-end ratio is the percentage of your yearly gross income dedicated toward paying your mortgage each month. A good rule of thumb is that PITI (Principal, Interest, Taxes, and Insurance) should not exceed 28% of your gross income. However, many lenders let borrowers exceed 30%, and some even let borrowers exceed 40%.
The back-end ratio, also known as the debt-to-income ratio (DTI), calculates the percentage of your gross income required to cover your debts. Debts include your mortgage, credit card payments, child support and other loan payments. 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 expenses should not exceed $3,000.
A down payment of at least 20% of the purchase price of the home minimizes insurance requirements, but many lenders let buyers purchase a home with significantly smaller down payments. The down payment has a direct impact on your mortgage payment, and, therefore, also on both the front-end and back-end ratios. Larger down payments enable buyers to purchase more expensive homes.
Beyond the Mortgage
Buying a new home is an exciting adventure. But many prospective homeowners, caught up in the thrill of searching for their dream house, forget to pause and consider the financial responsibilities of homeownership. While the mortgage is certainly the largest and most visible cost associated with a home, 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, like stoves, dishwashers, and refrigerators. The same applies to the roof, furnace, driveway, carpet and even the paint on the walls. If you are house poor at your 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, light, 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. But these expenses are unavoidable for most homeowners.
Many homes in 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. Ask about association fees prior to making a purchase. Find out about what the fee covers. In some communities, it includes lawn maintenance, snow removal, a community pool and other services. In other communities, the association fee covers little more than the administrative costs of hiring an attorney to encourage everyone in the neighborhood to maintain the exterior appearance of their homes. While an increasing number of lenders include association fees in the front-end ratio, it pays to remember that 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 big, empty rooms, which 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 their money on the house, and now can't afford curtains or furniture. Before you buy a new house, take a good look around the number of rooms that will need to be furnished and the number of windows that will need to be covered.
Basic Mortgage Terminology
When talking to your mortgage broker, it's important to know the terms he or she will use to describe your financial responsibility to the bank. The following is the list of most important terms to understand before you sign on the dotted line.
This is the face value of your mortgage on day one, and it represents the total amount of money you haven't repaid yet. If your mortgage is $400,000 on day one, then your principal is $400,000. A portion of each mortgage payment is dedicated to repayment of the principal. Loans are structured so that the amount of principal returned to the borrower starts out small and increases with each mortgage payment. While the mortgage payments in the first years consist primarily of interest payments, the payments in the final years consist primarily of principal repayment.
Interest Rate, also known as APR
This is how much interest accrues on your mortgage each year. Most times the calculator will ask you to enter this amount as a percentage and not a decimal unless otherwise specified. For example, if you have an interest rate of 4.25%, enter "4.25" instead of "0.0425." The interest rate, the lender's reward for taking on risk, has a direct impact on the size of a mortgage payment: If the interest rate on a $100,000 mortgage is 6%, the combined principal and interest monthly payment on a 30-year mortgage would be something like $599.55 ($500 interest + $99.55 principal). The same loan with a 9% interest rate results in a monthly payment of $804.62.
Mortgage Length, the Number of Payments and the "Amortization Period"
It's assumed that if you're using a mortgage calculator, you're using it before you take out your mortgage. If that's the case, these terms will be the same. But if you're midway through paying down your mortgage, you would want to find the "number of payments" by subtracting how many you've made from the total expected number of payments to find how many more are remaining. For example, if you have a 30-year mortgage (360 months), but just finished year two (24 months), then you would have 336 payments remaining (assuming your payments are monthly like most mortgages). The amount paid per period and the amount of interest you pay the bank are both determined by the number of your payments: more payments may mean each one is less in nominal dollars, but it could also mean you're paying more in interest.
This is a measure of the size of the mortgage compared to the home's value and is directly affected by the size of your down payment. If you take out a $160,000 mortgage on a $200,000 home after making a $40,000 down payment, your loan-to-value ratio is 80%.
Private Mortgage Insurance (PMI)
Lenders will typically require you to buy PMI if your loan-to-value ratio is more than 80% – your down payment was less than 20% of the purchase price – and will continue to charge you this premium until it dips to 78%.
Homeowner's insurance: Often bundled with mortgage payments, make sure you know your homeowner's insurance premium every month (or at least make an educated guess if you don't know it yet).
If you've taken out an adjustable-rate mortgage, adjustments are how many percentage points your interest rate increases/decreases after a pre-determined period.
Real estate taxes are assessed by governments and used to fund various public services such as school construction and police and fire department services. Taxes are calculated by the government on a per-year basis, but individuals can pay these taxes as part of their monthly payments. The amount that is due in taxes is divided by the total number of monthly mortgage payments in a given year, so borrowers should look at a past property tax bill or a property tax estimator for the area to know how much this might add to the bill. The lender collects the payments and holds them in escrow until the taxes are due to be paid.
The Bottom Line
Buying a new home is an exciting adventure. But many prospective homeowners, caught up in the thrill of searching for their dream house, forget to pause and consider the financial responsibilities of homeownership. While the mortgage is certainly the largest and most visible cost associated with a home, 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.