It’s easy to get carried away with the excitement of potentially buying a home – but before you even start your search, you must first focus on your home buying budget.
How much can you afford to pay for your mortgage each month? And what price does this payment correspond to? These are essential questions that you need to answer.
Understanding these numbers can help you set realistic and manageable expectations and keep your home search on track. Here’s how to determine them.
What can you afford?
To get started, you’ll need a good understanding of your finances, specifically the total income you bring in each month and the monthly payments for any debts you have (student loans, car loans, etc.).
As a general rule, no more than 25% to 28% of your monthly income should go towards your mortgage payment, based on Freddie Mac. You can plug these numbers (plus your estimated down payment) into a mortgage affordability calculator to break down the monthly payment you can afford and your desired home price.
Keep in mind that this is only a rough estimate. You also need to consider the consistency of your income. If your income fluctuates or is unpredictable, you may want to aim for a lower monthly payment to relieve some financial pressure.
The mortgage you can afford versus what you qualify for
While the steps above can give you a good idea of what you can afford, the number you get may not match what a mortgage lender thinks you qualify for when you apply.
Mortgage lenders base your loan amount and monthly payment on several factors, including:
- Credit score: Your credit score strongly influences your interest rate, which plays an important role in your monthly payments and the costs of your long-term loan. Higher credit scores usually mean (and lower monthly payments). The lowest rates are generally reserved for borrowers with 740 scores or higher, according to data from Fannie Mae.
- Debt to income ratio: Mortgage lenders also look at your debt-to-income ratio, or DTI, which indicates how much of your monthly income your debts take up. The lower your DTI, the larger the payment you can afford. Fannie Mae says lenders generally want your total debts – including your proposed mortgage payment – to be no more than 36% of your salary (although you may qualify with a DTI of up to 50% in some cases) .
- Your assets and your savings: The amount of savings you have in the bank and all , , stocks, bonds and other investments will also impact your loan. Having more of these liquid assets reduces risk and could influence the amount a lender is willing to lend you.
- Term of the loan: Longer-term loans come with smaller monthly payments because they spread the balance over more time. For example, a $300,000 mortgage (with a 10% down payment) at the current average rate of 5.23% over 30 years would cost approximately $1,487 per month for a 30-year loan. Meanwhile, the same $300,000 over a 15-year term would cost $2,048, or almost $600 more per month (based on an average interest rate of 4.38% over 15 years) .
- Type of loan: The type of loan you take out also matters. FHA loans, for example, have maximum loan limits that you cannot exceed. This year, the “floor” of the FHA’s national loan limit is $420,680, reports the US Department of Housing and Urban Development. Conventional loans are higher (up to $647,200 in most markets), while giant mortgages offer even higher limits.
- Rate type: Whether you choose a fixed or adjustable rate loan will also come into play. Adjustable rate loans generally have lower interest rates at the start of the loan, but increase over time. Fixed rate loans start with a higher rate but remain constant for the life of the loan.
When you apply for a mortgage, your lender will give you a loan estimate that details your loan amount, interest rate, monthly payment, and total cost of the loan. Loan offers can vary widely from lender to lender, so you’ll need quotes from a few different companies to ensure you get the best deal.
What other fees might be added to a mortgage payment?
While principal and interest will make up the bulk of your monthly mortgage payment, other costs can add to the overall payment amount.
: If your down payment is less than 20% of the purchase price of the home, your conventional mortgage lender may require you to purchase private mortgage insurance, a type of insurance policy that helps secure the lender if a homeowner ceases to make monthly payments. Although you can usually have it removed once you reach 20% equity, it will still increase your mortgage payments at first.
Property taxes: It is common for your property tax to be bundled with your monthly mortgage payment. These payments are usually paid into an escrow account and are automatically released when the invoice is due. Even if your property tax is not bundled, it is still a new cost to be accrued on a monthly basis.
How to qualify for a larger mortgage
If you don’t qualify for the mortgage you need to buy your ideal home, there are ways to increase your eligibility.
To start, work on improving your credit score. If you can qualify for a lower rate, it will allow you to buy in a higher price range.
For example: Suppose the maximum mortgage payment you can afford is $1,500. At a rate of 5%, this would give you a purchase budget of approximately $280,000. If you could instead benefit from a rate of 3%, you would obtain a loan of $356,000, or almost $70,000 more.
You can also increase your income, either by taking a side gig or by working overtime. Reducing your debt will also put you in a better position to get a bigger loan. The more income you are able to generate each month, the more the lender will be willing to lend to you.