How Much Home Can I Afford?

Part 1 of the Series: Empowering Homebuyers Through Education

For most people, home affordability ultimately depends on the answer to the question: how much is a bank or mortgage company willing to lend to me? Unfortunately, due to the lack of transparency in mortgage lending, the only way to know the answer to this question is to have a lender’s sales rep tell you. This is despite the fact that nearly all lenders use a universal set of guidelines to approve loans, which could easily be shared with you, the borrower, to help you make a more informed decision.

You might be wondering, what about the mortgage calculators that exist on the internet? Can’t these help me answer this question? While these tools can provide some value, the problem is that the output is only as good as the input; and without a precise account of your monthly debt obligations and an exact understanding of how a lender will calculate your monthly income, these tools often mislead you more than they help you.

You now have reached the point in the article where some of you start to feel helpless because you don’t want to rely on a salesperson, who has misaligned incentives, to try and answer this very important question. Well, don’t be dismayed. We are working day and night to put borrowers like you in control of the home financing process by giving you sophisticated tools, free of charge, that will allow you to determine exactly how much you can afford. In the meantime, though, here is an unbiased overview to get you started:

The amount a bank or mortgage company is willing to lend to you depends on two primary factors:

How much money you will personally contribute to buy your home (i.e. your “down payment”)
How much money you make relative to your debts

How much money you contribute to buy your home

The reason lenders care how much money you “put down” is because it lowers the amount of money they need to lend you to purchase your home. Furthermore, the more money you put down, the less likely you are to stop making your payments since you have more “equity” into the transaction. Hypothetically speaking, in a scenario where your financial circumstances deteriorate, if you only put 10% down, you are more likely to stop making payments than somebody who has 30% equity, because you have less money to lose. This is why lenders provide better terms to borrowers who make larger down payments.

Lenders quantify the amount you are willing to put down using a ratio called the Loan-to-Value Ratio (LTV), which is calculated as follows:

Loan-to-Value Ratio = Loan amount / Appraised value of the property

In order for you to get the best terms on your loan, lenders will require that you put at least 20% of your own money into the transaction, resulting in an 80% LTV. There are programs where you are able to put as little as 3% down, but these come with higher interest rates and additional monthly payments (e.g. Private Mortgage Insurance (PMI)). We will explain the down payment options in more detail in a future article.

How much money you make relative to your debts

Lenders care about how much money you make relative to your debts because they need to be sure you have the capacity to make your mortgage payment every single month. Lenders measure this with another universally accepted ratio, the Debt-to-Income ratio (DTI), which is calculated as follows:

The Debt-to-Income ratio = Total monthly debt obligations/Gross monthly income

Your total monthly debt obligations will include your mortgage payment along with the taxes and insurance payments associated with the property you are buying. Lenders get an accurate account of your other monthly debt obligations by requesting a credit report from the credit bureaus (we will explain this concept in more detail in a future article).

A DTI at or below 43% is typically accepted by all lenders. Calculating this ratio can become more complex if you derive income from multiple sources (e.g. rental properties) or your income can vary (e.g. commission and/or bonus income). If your DTI is more than 43%, you will likely need to lower your monthly debt obligations to lower the ratio to below 43%.

Getting approved for a home loan involves many more factors than the aforementioned ratios. Though, before you can even begin the process of thinking about buying a home, you need to know how much you can afford. Understanding these two ratios is a critical first step to figuring this out.

If you have any questions about any aspect of this article, please share them with us in the comment section. We will respond to all questions so everyone can benefit. If you like this post or think someone can benefit from it, please recommend it.

More from the series: Empowering Homebuyers Through Education

Next article: What does being pre-approved really mean?

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