Calculate What You Can Afford

TLDR: You need to know what you can afford so you know what price range of properties you should be looking in.

“Can I afford a luxurious mansion, or only a dilapidated, almost-certainly-haunted house?”

You’re browsing homes on Zillow, Trulia, or some other house-hunting site and you see a home price: $250,000. What exactly does that mean for you, both in terms of what you would need to pay as the down payment and also what the monthly payment would be? Should you even be looking in that price range? Will a bank approve you for that amount? Without knowing how much you’ll need to pay every month and at closing, the asking price is just an arbitrary number to you.

There’s a lot more to the question of “What can I afford?” than you might initially think. How much lenders will lend depends on a lot of factors, but it ultimately boils down to this: The less risky you are to the lender, the better terms you’ll get, and the more house you'll be able to afford. So, how can you reduce the risk you pose to the lender?

What factors affect affordability?

Lenders are number crunchers, and they prefer safe, risk-averse investments. When determining how much you’ll be approved for, banks look at the following factors:

Credit History

Have you proven you're trustworthy and repay your debts?

While this factor doesn’t directly influence how much you can afford, it does affect the interest rate you’re offered, which directly impacts what you can afford. Proving you’re a reliable borrower will go a long way toward getting approved for a loan.

Down Payment

How much skin in the game will you have?

The more you put down, the better the interest rate you’ll be offered. If you put down at least 20%, you also won’t be required to pay PMI.

Debt-to-Income Ratio

Do you have enough flexibility in your budget to pay the mortgage in addition to your other debts and still have wiggle room in the event of unexpected expenses?

Banks will factor in your household income, and all of the outstanding debts you have: think car payments, student loans, credit card debt, etc. Typically banks won’t lend more than 43% DTI, and they prefer to keep the DTI at less than 36%.

Market Interest Rate

How is the economy doing?

This will depend largely on the Federal Reserve’s current interest rate.

Loan Type

Will you be getting a 15 or 30 year amortizing loan?

You’ll be offered a lower interest rate if you select a shorter repayment period, and you might be surprised at the difference (it’s less than one might expect!).

All of this information cumulates into how risky the bank deems you, and will dictate not only if you get approved, but also the interest rate you're offered.

Unless you have way more control than the average person over increasing your salary and decreasing your expenses, the three factors that you can influence most are the length of the loan, the size of your down payment, and your credit score, with the latter two influencing your interest rate. While your credit score doesn't have a direct impact on how much house you can afford, it does affect the interest rate you're offered, so it has a substantial indirect influence over what you'll be able to afford. You can’t improve your credit score or save up a down payment overnight, so it’s beneficial to plan your purchase in advance.

Example: How is my maximum purchase price calculated?

Understanding affordability is easiest when you take a look at your monthly income and expenses, determine what you can afford per month for a mortgage payment, and use that information to calculate the maximum price range you should be looking in.

With a 36% Debt-to-Income ratio, your debts should total no more than $1,800 per month. If you’ve already got existing monthly debts, we can calculate how much you can afford per month for your mortgage payment.

Now that we’ve calculated our maximum mortgage payment, we can look at how interest rates affect affordability.

How do interest rates affect affordability?

How does the math work? Let’s assume taxes and insurance are fixed costs (not adjustable), but we’ll tinker with the other factors: principal and interest. If the interest rate is higher, a bigger proportion of your monthly payment will go toward interest as opposed to principal, so you’ll be able to afford a lower purchase price. If the interest rate is lower, a bigger percentage of each monthly payment will be able to go toward principal, affording you “more house” in the form of a higher purchase price.

What can I do to get a good interest rate?

While you won’t be able to single-handedly change the market interest rate (unless you’re chairman of the Federal Reserve), here are some things you can do to get a better interest rate:

To emphasize the impact interest rates can have, let’s look at the difference a quarter of a percent of interest will save on an amortizing 30 year loan. That’s over $15,000 because of one quarter of one percent in interest!

How does the size of the down payment affect affordability?

In addition to increasing the monthly mortgage payment, putting less than 20% down on a house will result in the lender requiring you to pay Private Mortgage Insurance, more commonly known as PMI. Because you'll have put less money down and as such have little to lose if you walk away from the mortgage during tough times, Private Mortgage Insurance protects the bank in the event that you default on the mortgage.

Similar to other insurances, the more risk you pose, the higher your PMI payment will be. The factors that affect the interest rate you're offered also affect PMI. PMI is also calculated based on your loan balance, so it will be proportional to the size of the loan, ranging from 0.25% to 2% of the principal balance.

Putting less than 20% down also means the interest rate you'll be offered will be higher. That isn't to say that you can't or shouldn't put less than 20% down, it's just to note that your loan will be approved for less than you would get when paying a larger down payment.

Fun Fact

The lender is federally required to automatically cancel PMI once the borrower has paid a total of 22% of the purchase price (your down payment counts toward this percentage). You're also able to ask the lender to stop charging PMI after you own 20% of the property, so mark your calendar.