11 Key Considerations to Know How Much House You Can Afford

What you pay in rent isn’t necessarily how much house you can afford. There are many factors and a number of other considerations.

Figuring how much house you can afford boils down to your annual income, down payment, debt-to-income ratio, and your credit score. These all impact what your monthly payment will look like and what type of loan and interest rate you’ll be able to get.

On top of those factors, it’s important to also consider any future repairs, expected home maintenance, and annual property taxes.

Whether you need more space to start a new family or are discovering that buying is cheaper than renting – now’s as good a time as any to find your next home. Before you buy, it’s important to make sure you can live comfortably while also paying your loan.

Remember — your first home doesn’t have to be your forever home. On average, Americans move once every 7 years.

Below are the 11 factors that help you determine what kind of home you can afford.

1. Annual income is the biggest factor when deciding your housing budget.

What kind of house you can afford is a direct result of your household’s shared annual income.

This is the money you earn in a year from all money sources, pre-taxes and it has a direct correlation to what kind of house you’re going to be able to afford. This includes:

Salary
Bonuses and commissions
Dividends paid on investments

To accurately assess your buying potential, subtract your annual tax payments from all annual income. For insight on future expected earnings, average the last five years of tax payments with your projected, post-tax earnings for the next five years. This will account for yearly taxes by month, providing a clear picture of what’s available for mortgage payments.

2. Maintain a low debt-to-income ratio to qualify for a loan

Your debt-to-income ratio (DTI) is exactly what it sounds like. It’s the percentage of your monthly income used to pay off debts. This includes things like:

Credit cards
Student loans
Auto loans
Insurance premiums

Lenders use the 28/36 rule to qualify or disqualify mortgage applicants. The rule breaks down like this:

If your mortgage requires a payment of more than 28% of your gross monthly income, you won’t qualify for a home loan.
If your total outstanding debt requires a payment of more than 36% of your gross monthly income, you won’t qualify for a loan.

Only in rare cases where buyers have excellent credit history will lenders approve a loan in excess of the 28/36 rule.

Find out your debt-to-income ratio with this DTI calculator.

A low DTI shows a good balance between debt and income, which signals that you are likely to repay your loan.

Calculate DTI by dividing total recurring monthly debt by gross monthly income. For example, if your monthly mortgage payment is $1,000 dollars and you earn $4,000 per month, your DTI is an acceptable 25%.

However, if you’re also paying off a $500 monthly auto loan and a $250 monthly student loan, your monthly debt totals $1,750. This brings your DTI to 43.75%, which disqualifies you from a mortgage loan.

If you’re DTI exceeds 28% or 36% respectively, paying a mortgage will be difficult. Better to resolve your debts, save money, and put down a healthy down payment instead of risking a loan default.

3. Your credit score has a huge impact on how much house you can afford

It’s the number that indicates how you’ve borrowed and repaid money in the past. Above, we see what factors FICO uses to assess credit ratings.

Your credit score indicates your likeliness to make loan payments on time. It directly affects:

Your ability to qualify for a mortgage
The total loan amount available
Mortgage interest rates you are likely to receive

A low credit score indicates past issues with credit repayment, so borrowers with lower scores pay higher interest rates. This effectively inflates the cost of homeownership throughout the mortgage span while also increasing the monthly payment.

The difference between interest rates can vary up to two percentage points. This seems minor, yet adds up to thousands of dollars over time.

For instance, a buyer with a $100,000 loan & 3.5% interest rate will pay $7,000 interest for the first ten years. If he or she had a higher interest rate of 5.5%, the interest payments on the same loan amount would be $11,000.

So, what credit score do you need to get a 3.5% interest rate?

Four credit score ranges exist:

750 or higher qualify for the best interest rates.
650-750 receives a good interest rate, but less so nearer to 650.
650 or lower is where getting a mortgage becomes very hard and interest rates climb.
560 or lower has an impossible time receiving a loan.

Here is how to assess your credit score. Improving your credit is the best way to secure lower interest rates and reduce the costs of homeownership, but it takes time.

4. Your down payment impacts future interest and monthly payments

A down payment is the initial payment made when buying a house.

The smaller the down payment, the more you’ll pay in interest over the course of your home loan.

The standard down payment is 20% of the home price. Putting down the recommended 20% keeps interest rates low, plus reduces your monthly payments.

However, down payments vary. If you take out an FHA loan, your initial down payment amount can be as low as 3.5%. However, with upfront smaller payments, lenders often require private mortgage insurance (PMI) since they view it as a riskier loan.

Expect PMI payments to add on .3-1.5% of the total mortgage amount per year. PMI coverage will also increase your monthly mortgage payment.

5. Calculate monthly expenses to include your mortgage payment

Many first-time homeowners don’t consider their pre-existing costs, leaving them “house poor.” Calculating your income in relation to the cost of monthly expenses will ensure you make a smart purchase. Taking on a mortgage loan adds to your monthly expenses. To get a sense of total monthly expenditures with a mortgage, go through your pre-purchase finances in detail.

Consider what you spend per month on:

Groceries
Insurance
Rent
Utilities
Gasoline
Eating out
Phone and media
Debts
Other necessities

Subtract these living expenses from your post-tax monthly income. Tally any savings you want to pay into, plus any emergency funds and other foreseeable costs into this monthly figure.

After accounting for expenses, is your resource pool big enough to pay for a mortgage? Be realistic about this number as it can only hurt you if you aren’t.

6. What type of loan do you need?

Not all mortgage loans are created equal. In fact, there are four different loan types that exist. Each comes with costs and benefits that will affect your monthly payment amount.

Fixed-rate loans: The interest rate on fixed-rate loans doesn’t change during the mortgage payment term. If you secure a 3% interest rate for good credit, it will be the same in 5, 15, or 30 years. This helps you calculate all expenses pre-purchase and provides a stable financial framework.

Our recommendation: Fixed-rate loans are best for most home buyers, especially those looking to secure a mid to long-term mortgage at a low interest rate.

Adjustable-rate mortgage loans (ARMs): The interest on ARMs fluctuate over time. Since these loans generally start with a lower interest rate, some people prefer them because they can save money up front.

For example, a 10/1 ARM loan will have a fixed rate for 10 years, then change every year after that, often increasing. Given the volatility of interest rates, these are riskier loans. However, sometimes the market sets the fixed rate higher than the average adjustable rate.

Our recommendation: ARM loans are best for buyers with funds for a higher down payment and are considering selling their home soon for a financial gain, given the housing market.

You can also choose between a conventional loan or an FHA loan.

Conventional loans: These are independent loans that don’t involve the government. Conventional loans favor those with good credit, especially since any private mortgage insurance (PMI) is cancellable after the home reaches 20% equity. Given by private lenders, these are most common and most cost-effective.

Our recommendation: Conventional loans are best for buyers with average to excellent credit, a low DTI-ratio, and who’s down payment is above 5% of total home value.

FHA Loans: These are loans managed by the Federal Housing Administration and available to everyone. Credit score is less of a factor here, as FHA loans allow as little as 3.5% of the total home price for a down payment. The drawback of FHA loans is paying PMI throughout the duration of the loan, which raises your monthly payments. This option is ideal if you’ve got low credit or a high DTI-ratio.

Our recommendation: FHA Loans are best for buyers with low to average credit or a high DTI-ratio.

7. What loan term is best for you?

Choosing the right loan term for your budget will help you determine total home costs, both now and into the future.

Typically, longer term loans have higher interest rates but lower monthly payments. Shorter loan terms have higher monthly payments with lower interest rates.

Loan terms and interest rates are interconnected. Interest rates are often expressed as annual percentage rate (APR).

If you’ve got the cash, a shorter 15-year loan would save you thousands on interest through the years. If you opt for a 30-year loan, expect to pay more interest but enjoy a more leisurely payment plan.

8. What does your annual percentage rate (APR) affect?

Calculating your APR provides a more realistic picture of exactly how much you’ll be paying on your annual mortgage, and per month.

APR includes any fees, taxes or mortgage insurance associated with the mortgage transaction, so it’s a more accurate – though higher – number than your basic interest rate.

For example, if you take a loan for $100,000 at a 5% interest rate, your annual interest totals $5,000 ($417/month). But, let’s also assume your mortgage includes mortgage insurance and transaction costs that total another $5,000.

Determine your APR by first adding the $100,000 mortgage to the $5,000 in additional fees. All included, your annual interest on $105,000 comes to $5,250 instead of $5,000.

Divide the $5,250 annual payment by the $100,000 loan to get your APR of 5.25%.

9. What goes into my monthly mortgage payment?

Your monthly mortgage payment is the amount paid per month during the loan term.

Monthly mortgage payments are influenced by six primary factors:

Credit score
Credit history
Annual income
Total debt
Down payment
Interest rates

Any homeowners association fees (HOA) and PMI payments will increase your monthly payment. HOA fees are flat monthly payment paid by owners of certain residential properties for routine maintenance and improvements. They typically range between $200-400 per month.

10. Will my new home need any repairs before move-in?

Most likely, you’ll want to retouch or remodel your space to make it yours, which means more costs.

Homeownership also means paying for any ongoing repairs or renovations.

At the time of purchase, calculate the expected costs of future repairs, replacements or upgrades. Homes that require serious overhauls and continuous maintenance are very costly, often in unforeseen ways. If you’re fond of home repair, you can minimize these costs. Use this TrueCost Guide to estimate your costs by city.

Regardless, account for the costs of upkeep and repairs for your new home so you don’t get hit with any unexpected expenses.

11. Last, but definitely not least, account for your annual property tax.

The city or county you live in will require you to pay annual property tax twice per year. This typically gets rolled in to your monthly mortgage payment. Your property tax can add hundreds to your monthly payment, but it’s also a deductible expense.

To find your annual property tax, multiply the current property tax rate by the current market value of your home. This number varies by property location and property type.

Open Listings can access past tax records for the home in question. This way, you can see past payments and estimate your personal tax amount.

Now, go find the best home for you.

By reading this guide, you’ve taken the guesswork out of home affordability. To determine how much house you can afford, be meticulous about assembling and calculating these factors.

Begin by assessing your monthly expenses and annual income. This will deliver an accurate view of what you can spend per month, which allows you to figure out how much down payment you can afford. Now you can choose the perfect loan to suit your budget and timeline.
Search for your perfect home in a location that aligns with your future dreams and provides great value.
Predict your interest rate based on your credit score
Determine your debt-to-income ratio to see if you qualify for a loan.
The costs of homeownership also includes repairs…
And don’t forget to account for annual property tax.

Home buying today is easier than ever because of so many resources close at hand. Get the tools you need to discover which home will soon be yours.

This article originally appeared on OpenListings.

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