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To determine how much mortgage you can afford, you should consider several factors, including the funds you have available to use as a down payment, your monthly expenses (including debt payments) and what portion of your income you'll need to cover the monthly mortgage payments.
Check Your Credit Reports and Scores
When you apply for a mortgage, most lenders request your credit report and credit score from one or more of the three national credit bureaus (Experian, TransUnion and Equifax). If your credit score falls below a minimum threshold (determined at the discretion of the lender), your application may be turned down. Mortgage lenders' credit score requirements vary, but a minimum of 620 on the FICO scale of 300 to 850 is not unusual for a mortgage, and most lenders will reject applicants with FICO® Scores* below 580.
If your credit score barely meets the lender's minimum requirements, you can expect to pay comparatively high interest rates and fees on the loan. Lenders typically charge borrowers with lower credit scores more than those with higher scores. The difference between a "fair" FICO® Score and one in the "good" range can mean thousands of dollars in savings over the life of a mortgage.
In addition to checking your credit scores, most lenders will look closely at the credit reports they're based on. Negative entries in a report such as late or missed payments, accounts transferred to collection agencies, or more severe items such as foreclosures or bankruptcies can also be grounds for a mortgage application being rejected.
To know where you stand before seeking a mortgage, it's a good idea to check your credit report and credit score at least three to six months before you apply for a loan. You can get a copy of your credit report from each credit bureau once a year at AnnualCreditReport.com, or get your Experan credit report and score for free. Review your credit report carefully and consider taking steps to get your credit mortgage-ready:
- Inaccurate information on your credit report can hurt your credit score, so if you find any, follow up with the credit bureaus to make any necessary corrections.
- If your credit score is lower than you'd like, consider taking six months to a year to try to improve your credit score before applying for a mortgage.
- If you're ready to proceed with your home search, avoid applying for new loans or credit cards at least six months before applying for your mortgage (or mortgage preapproval). The credit checks associated with those applications temporarily lower your credit scores, which can work against you when you apply for a mortgage. Taking on additional debt also increases your debt-to-income ratio.
Consider Your Income and Debt
When you apply for a mortgage loan, one of a lender's chief considerations will be your debt-to-income (DTI) ratio, which is the portion of your monthly income that goes toward debt payments. To calculate your DTI ratio, add up your recurring debt-related expenses (credit card bills, student loans, auto loans, etc.) and divide that sum by your gross monthly income (the amount you earn before expenses, withholding taxes, retirement savings, etc.). If your gross earnings are $6,000 a month and the sum of your total debt-related expenses is $2,700, your DTI ratio is 2,700/6,000, or 45%. From a lender's point of view, the lower your DTI ratio, the better, because somebody with a high DTI ratio may have difficulty covering the additional debt payments of a mortgage loan.
The maximum acceptable DTI ratio varies among lenders, but borrowers who receive qualified mortgages that meet federal home-lending guidelines must have a DTI ratio of 43% or lower, and many lenders look for a DTI no higher than 36%.
Decide How Much Money to Put Down
The amount of cash you put toward a down payment plays a major role in determining how much house and mortgage you can afford. It helps determine the amount the lender is willing to loan you and the fees and the interest charges that will apply. Those numbers, in turn, determine the amount of your monthly mortgage payment.
When deciding how large a down payment to make, it's helpful to understand how mortgage lenders think about down payments. Instead of focusing on the down payment itself, lenders focus on the percentage of a property's value that isn't covered by the down payment—that is, the portion of the property value that they are willing to cover with a loan. Lenders (and the federal authorities who regulate them) refer to this using a figure known as loan-to-value (LTV) ratio, calculated by dividing the amount of the loan by the price of the property:
In the case of a $200,000 house, if you make a 10% down payment ($20,000) on the property, the LTV ratio on the amount you'd need to borrow to buy the property would be $180,000 divided by $200,000, or 90%. If you increase your down payment to $30,000 (15% of the purchase price), the LTV ratio would decrease to 85%.
"Conforming mortgages" that meet the purchase requirements set by Fannie Mae and Freddie Mac, the government-sponsored enterprises that eventually buy most U.S. single-family-home mortgages, can have LTV ratios no greater than 80%—meaning down a payment of at least 20%.
Conventional mortgage lenders may issue "nonconforming" loans with LTV ratios as high as 95% (or down payments as little as 5%). The interest rates and fees on these loans are typically much higher than on conforming loans, and borrowers with LTVs greater than 80% are typically required to buy private mortgage insurance, which can increase in monthly mortgage payments.
In addition to its importance in determining the total amount you can borrow, your down payment amount often plays a role in setting the origination fees, you typically pay when you take out a mortgage loan. Many lenders give borrowers the option of trading a higher down payment for reductions in origination fees. Fees are expressed in terms of percentage points of the loan amount, or simply "points," and buying these "discount points" can mean major savings over the life of a loan.
Consider the Mortgage Term
The interest rate that applies to your mortgage is the single biggest determinant of what your loan will cost you over time, but the amount of time you'll be making payments is a huge factor as well.
U.S. mortgages loans typically carry repayment periods of 15 years or 30 years, although longer and shorter repayment periods are available. Shorter loan periods typically come with lower interest rates, and because those rates are applied for a much shorter length of time, their costs over the life of the loan are considerably lower than on longer loans. The main advantage to longer-term loans is that stretching repayment over a longer time frame means lower monthly payments.
To illustrate the significance of repayment terms alone, holding other factors equal, consider the differences in monthly payment amount and total cost (principal and interest) between 15-year and 30-year mortgages on an average U.S. home priced at $226,800. For comparison purposes, we'll assume the interest rate on both loans is 4.5%, and that you made a down payment of 20% ($45,360), so PMI isn't a consideration:
|How a Mortgage Term Affects What You'll Pay|
|15-year Mortgage||30-year Mortgage|
|Home purchase price||$226,800||$226,800|
|Down payment||$45,360 (20%)||$45,360 (20%)|
|Total repayment amount||$255,632||$343,618|
Consider the Costs Beyond the Mortgage
When determining how much you can afford to budget each month to cover your mortgage, don't forget that you'll likely incur a number of new expenses beyond the mortgage when you become a homeowner. Be sure your planning allows sufficient funds to cover expenses such as:
- Property taxes
- Homeowners insurance (including basic casualty coverage as well as applicable riders for earthquakes, wildfires, floods and other natural disasters, which many lenders require on homes in susceptible parts of the country)
- Building association dues (where they apply)
- Home maintenance, repair or renovation
Depending on the age and condition of your home when you buy it, you may need to plan for the cost to replace a roof, furnace, HVAC unit or to update appliances or other features of the home. Setting some funds aside for those projects each month can help prevent them from becoming emergencies down the line.
Look Into Different Types of Mortgage Loans
Once you've determined how much you have to use as a down payment, and how much you can afford for a monthly mortgage payment, start comparing mortgage offers. Once you settle on a lender you like, consider getting preapproved for a mortgage before you begin shopping for a home.
If you're a first-time homebuyer, a service member or veteran (or the surviving spouse of one), or are looking for a home in a rural part of the country and you meet certain income requirements, you may qualify for one or more federal programs designed to help Americans become homeowners. A licensed real estate professional or a loan officer at a bank, credit union or home lender can help you decide which programs you qualify for, and which mortgage type is best for you.