One of the most common first-time homebuyer questions is how much can I afford to buy? Home affordability weighs on many factors that your lender will analyze to give you an appropriate, pre-approved purchase point.
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Your Mortgage Rate
Homebuyers have been enjoying historically low mortgage rates for the past several years. Did you know the average 30-year fixed mortgage rate in the 1980’s was 12.7 percent?
Mortgage rates fluctuate constantly, and even a relatively small bump in rates can change your purchase power circumstance. For instance, let’s say you financed your home purchase with a $200,000 30-year fixed rate home loan with a 3.75 percent interest. Your monthly principal and interest payment would amount to $926.
If your rate increased to 4.25 percent, the monthly principal and interest payment would increase by nearly $60.
Your Credit Score
You credit score is used to determine how risky of a borrower you are, which is why borrowers with higher credit scores typically receive lower interest rates.
Having a low credit score doesn’t necessarily mean your dreams of buying a home are out of reach, but if your loan type partly determines your interest rate based on your credit score, it could limit your buying power.
Your Down Payment
Contrary to popular belief, you no longer need the status quo 20 percent down to buy a home. In fact, there are some loan options that will finance 100 percent of your home purchase. On the flipside, there are some benefits to applying a 20 percent down payment if you can swing it.
With a 20 down payment you can eliminate the need and cost of private mortgage insurance, which is typically required for homebuyers who finance with less than 20 percent down.
A higher down payment can also lower the interest rate offered to you and in some markets, give you a competitive edge against other buyers.
Private Mortgage Insurance
As mentioned above, most homebuyers who purchase with less than 20 percent down are required to pay for private mortgage insurance (PMI). The purpose of PMI is to protect lenders in the case that a borrower defaults on their mortgage. PMI also gives buyers that ability to purchase without a hefty down payment.
Private mortgage insurance rates are determined by which loan program you choose to use and your credit score.
Though you don’t have to be debt-free to buy a home, student loans, auto loans, credit card debt, etc. can limit your purchase power.
Most lenders recommend that your mortgage payment, including principal, interest, taxes and insurance (homeowners and private mortgage insurance, if applicable), be less than 28 percent of your gross monthly income. This is known as your front-end ratio.
Your lender will also analyze your debt-to-income ratio, or back-end ratio, which includes your monthly obligations like credit card minimum payments, student loans, alimony, child support and car loans along with your principal, interest, taxes and insurance. Lenders ideally want this to be at or below 36 percent of your gross monthly income.
So let’s say your total household gross monthly income is $6,250 ($75,000/year). Ideally, your total mortgage payment alongside your other monthly debt payments should be in the ballpark of $2,250 or less.
Property Taxes and Homeowners Insurance
Taxes and insurance are an inevitable and important part of the homebuying process and their cost is variable pending multiple items. Property taxation is based on a home’s assessed value and local millage rates, so even with a fixed rate mortgage, your property taxes can fluctuate over time.
Homeowners insurance is determined based on a large amount of items related to your home purchase, including your home’s age, building materials and location. A home insurer will also take a look at your credit score when offering a quote. Certain aspects of your homeowners insurance can be adapted to meet your own personal needs, like increasing the amount of liability protection you have in case someone is injured on your property or bumping up your personal property insurance to cover valuables like jewelry, which would increase your insurance quote.
Your Own Homebuying Budget
Though your lender determines your mortgage affordability, just because you are pre-approved up to a certain dollar amount does not mean you need to spend on the high end of the spectrum.
Remember to incorporate the costs of homeownership into your budget, including utilities, home improvements, closing costs, etc. Though homebuying is cheaper overall than renting, it’s important to stay within your own personal comfort zone.
Regardless, there are a lot of factors that determine your loan eligibility and your purchase power. Before you jump ahead to selecting potential homes to purchase, meet with a lender for a pre-approval or loan commitment.
Want to know more about what it takes to buy a home? Download our free Mortgage 101 Handbook for everything you need to know about the homebuying and financing process.