Buying a home may be one of the most expensive purchases you’ll make so it’s important to consider your budget carefully before setting out on the search for your dream home. And this starts with one question: “How much mortgage can I afford?”
When answering this question, you need to set realistic expectations by considering your finances, borrowing options, and the total costs of buying. Read on below as we further discuss the best tips for determining how much mortgage you can afford.
Know Your Credit History
When you apply for a mortgage, your credit reports from the three main bureaus — Equifax, Experian, and TransUnion — will be obtained to determine your creditworthiness. This provides your lender a summary of your credit history including your credit card accounts, loans, balances, and payment history.
In addition to checking to ensure your bills are paid on time, lenders will also analyze how much of your available credit you actively use, known as credit utilization. Maintaining a credit utilization rate at or below 30 percent boosts your credit score and demonstrates that you manage your debt wisely.
Looking at all of this information will allow a lender to calculate your FICO score, a credit score model used by lenders, ranging from 300 (poor) to 850 (exceptional). If this information is new to you, we recommend reading this guide to familiarize yourself with the home buying process before moving on!
Calculate Your DTI and Housing Ratios
Mortgage lenders calculate your current debt based on how much money you make. This is known as your debt-to-income (DTI) ratio.
The most important ratio referenced by most lenders is your front-end and back-end ratios. Your front-end ratio is calculated by taking your proposed housing expense divided by your gross, pre-tax income. Keeping this percentage right around 28% is the most competitive offering you the best options as a homebuyer.
The other ratio involves all your current loan payments, including housing expenses and monthly debts (but not utilities or other living expenses), divided by your gross monthly income. Keeping this number right around 36% ensures you won’t be stretching limits in affording a new home. This is referred to as your back-end ratio.
Lowering Your DTI
Lowering your DTI can have a big impact on the type of financing you can get. If you have some flexibility when you plan on buying, taking time to lower your DTI (and improve your credit score) can save you a lot of money over the life of your loan.
If you plan on making any big purchases — such as a car or new appliances — wait until after you’ve bought your home. This will ensure you are not overextending yourself with a variety of debts.
If you plan on living with a partner, parent, or roommate in your new home, bring this up early on in the approval process. Lenders could be able to include some of their income in your DTI calculation.
Interest Rates: Fixed-Rate vs. ARM
Think of interest as the price you pay for using someone else’s money until you pay it back. More specifically, your mortgage rate is what it costs each year to borrow the money and is expressed as a percentage. Generally, the amount of interest you pay every month is added to the amount still owed on a loan, also known as the principal that you repay monthly.
You’ll typically see two types of mortgage interest rates: fixed rates and adjustable rates.
Fixed interest rates stay the same for the entire length of your mortgage loan. This offers a predictable payment each month and makes budgeting easier.
An adjustable-rate mortgage (ARM) uses a rate that varies based on the market. Therefore, the monthly payment may change over time as your interest rate increases or decreases along with market trends. Most ARMs do have a limit on how much the interest rate can fluctuate and how frequently it can be changed.
Understanding Annual Percentage Rate (APR)
We’ve been over what interest is and how interest rates relate to mortgage loans. To understand the full picture you should also consider how Annual Percentage Rates or APRs work.
An advertised interest rate isn’t the same as your loan’s APR, which is the annual cost of a loan to you as the borrower and includes fees and other charges such as mortgage insurance, most closing costs, discount points, and loan origination fees.
So you might be wondering why both an interest rate and an APR are presented with your loan offer? The APR is intended to give you more information about what you’re really paying.
Every lender must follow the same rules to ensure the accuracy of the APR.
You can use the APR as a good basis for comparing certain costs of loans to how much mortgage you can afford. Compare the interest rate and APR to ensure you are offered the most competitive rate when shopping for a loan.
The Down Payment
A down payment is how much you expect to put down or contribute to the purchase of your home. Whatever you don’t put down will likely have to be financed. Your down payment plays a big part in determining how affordable your mortgage will be.
You can use money from savings, investments, or other sources to make up your down payment. It is recommended that you put down 20% of the home’s purchase price, although government-specific loan types may enable you to put down as little as 3.5% or nothing at all.
Find Out How Much Mortgage You Can Afford With Belco!
We’ve covered ways to ensure your mortgage is affordable. Make it your next step to find the right mortgage lender — which is similar to finding the right home. Take the time to shop around and find the best fit for your financial situation and needs.
Click below to learn more tips on choosing a lender and the advantages of choosing a credit union!