Owning a home is the American Dream! Gorgeous interiors speckle Instagram, tiny homes are all the rage, and HGTV offers series upon series up series for those interested in house hunting right here in the U.S. to those interested in an international abode. It's clear how much we all love the idea of owning our very own little slice of land in the world.
Many of us dream of the homes we'll one day have from a young age. But what we don't realize when we're playing house is that actually buying a home, whether that's a sunny abode in Los Angeles or a classic New York brownstone, is a complex and complicated process. One of the most confusing parts of the process of figuring out how to cover the increasingly astronomical costs of buying a home.
This leaves many buyers with the burning question that is practically synonymous with buying a home: How much home can I afford?
We're here to help answer that. While every person's individual situation is unique, there are some general rules of thumb that help demystify what goes into determining loan amounts.
What Type of Home Loan Is Best For You?
This is the big question. Figuring out how much home you can afford isn't always the most straightforward question to answer. But with a little digging into your finances along with a little help from experts, it's pretty easy to get there.
The most direct answer is this: How much house you can afford is directly related to the size and type of mortgage you can qualify for. The size of a mortgage is the amount of money it offers you. When it comes to the type of mortgage, there are five general types of mortgages:
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A conventional loan which requires borrowers to pay for mortgage insurance if the down payment is less than 20% of the cost
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A jumbo loan is for borrowers with excellent credit scores who are looking to buy an expensive home
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A government-insured loan is often the best option for borrowers who have lower credit scores and don't have much cash to put towards a down payment
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Fixed-rate mortgages are loans that offer the same rate throughout the lifespan of the loan
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Adjustable-rate mortgages are best for borrowers who don't plan to stay in their home long-term and want to risk larger payments in the future
The first step in figuring out how much house you can afford is deciding what type of loan you'll want to pursue.
The rule of thumb for how much house I can afford: Figuring out how much house you can afford is a function of the size and kind of mortgage you qualify for.
How much of a home loan can I qualify for?
Figuring out the type of loan you want is relatively easy. The harder part is determining the size of the loan you can qualify for.
Unfortunately, because all lenders are different, there's no one-size-fits-all, hard and fast answer to this. There are, however, a few common practices that most lenders follow when determining the size of the loans they make.
What lenders care about: Gross income, debt-to-income ratio, and credit score
As Chase Bank explains, "lenders typically focus on three things: your gross income, your debt-to-income ratio (otherwise known as DTI), and your credit score."
Your gross income is the annual sum of all of the money you earn in a year before anything like taxes are taken out of it. Your debt to income ratio is determined by subtracting the debt you have from the money you make. By looking at your debt to income ratio and your gross income, lenders determine how much you could pay towards a mortgage each month.
If all of this feels too complicated to you, you're not alone. Luckily there are tools like NerdWallet's Mortgage Pre-Qualification Calculator that can help. While the numbers that this tool or any other mortgage quoting services should be considered as nothing more than the estimate that it is, they can help give you an idea of what you might expect from a lender.
The rule of thumb for home loans
If you want to qualify for a larger loan, increase your credit score and pay off as much pre-existing debt as you can. If you want to minimize your monthly loan payment, save for a larger down payment and select a longer mortgage term (although this means you'll likely pay more in interest over time).
How much of a mortgage can I afford?
Financing a home isn't just about figuring out how much of a home loan you can qualify for. Instead, you should try to figure out how much of a home loan you can responsibly take on. Just because you qualify for a $500,000 mortgage doesn't necessarily mean that taking on that much debt is the right route. The better question to ask, then, is what mortgage can I afford?
Understanding the salary to mortgage ratio
Mark Reyes, a Certified Financial Planner and financial advice expert, told CNBC that an ideal mortgage is no more than three times your annual salary. This is what's called the salary to mortgage ratio. Sometimes called the house to income ratio or the mortgage to income ratio, the rule means that if you make $50,000 a year, you probably shouldn't sign up for a home loan that's much larger than $150,000. Naturally, though, if you have a partner, then this is a function of both of your salaries.
Another approach: What percentage of my income should go to my mortgage?
Here's another way to frame the question: What percentage of my income should go to my mortgage? "You want to make sure that your monthly mortgage is no more than 28% of your monthly income,” Reyes said. “With a general budget, you want to have 50% of your income going toward utilities, mortgage, and other essentials."
Wrapping Up
If you follow this rule of thumb, chances are you'll have the flexibility you need to meet your other financial needs without feeling strapped by the cost of your mortgage.
The rule of thumb for mortgages: Avoid taking on home debt that is more than three times your annual salary.
IFiguring out how much house you can afford is not a simple task, but it's an essential one. Plus, the sooner you figure it out, the more time you have to make adjustments to your life that can impact the answer if you're not satisfied with what you find initially. It never hurts to research!
