How much home can I afford based on income?
Ask yourself two questions:
- How much should I borrow?
- How much would they lend me?
Potential homeowners usually ask the first without asking themselves the second question – and the second one is much more revealing. It’s not about what you’d like to do, and more about “what are my options?”
If you’re a first-time home buyer, you’ll also want to estimate your mortgage payment vs. monthly rent costs. Since landlords like to use the 40X-the-Rent rule, you may actually save money by buying a home.
Could vs. Should Dilemma
One of the fastest ways to see how much you can borrow is to pre-qualify.
A loan pre-qualification is convenient and quick—you can even do it online. It doesn’t give you a loan commitment or guarantee, but it’s a good first step to see the amount and type of loan a lender could offer you.
Working out a monthly household budget (one that includes all homeownership expenses) gives you the best estimate of how much you should borrow.
Things Lenders Look At
There are three key factors lenders look at when reviewing a home loan application. You can check them yourself too – in fact, that’s recommended before you start applying for loans.
#1. What You Owe vs. How Much You Make
This is what lenders refer to as a debt-to-income ratio (or DTI).
To calculate it, add your total monthly debt payments (personal loans, credit cards, etc.) to your projected monthly home payment. Then compare that number with your monthly pre-tax income.
Lenders ideally want your debt-to-income ratio to be lower than 36%.
#2. What’s Your Credit Score?
This number, which typically ranges from 300 – 850, is generated by the three major credit reporting agencies – it’s basically a financial profile of your credit health and payment history.
Having a “good” or “excellent” score demonstrates to a lender that you are less likely to default on the loan.
Pro Tip: A credit score lower than 620 makes it very difficult to obtain a loan.
Some lenders may decrease a down payment requirement if you have a good enough credit score. You can check get a free copy of your credit score by visiting the websites of the three credit reporting bureaus:
As a reference, a credit score 700-850 will open a lot of doors. Lenders view deem those with a high credit score to be “less risk”.
Read how credit scores limit financial options.
#3. How Much Is Your Down Payment?
This is the cash you put down for the home at closing. Depending on which loan programs you qualify for, a down payment can range anywhere from 3.5- 20%.
Offering a higher down payment tells a lender that you’re prepared to make a financial commitment to the home, which increases their confidence in your likelihood to repay the loan. It also puts you in a stronger position financially, as you won’t have to borrow as much from your lender.
If you want to offer less than 20% down, you may be required to carry private mortgage insurance (PMI) as an extra cost – approx. 1.5% of the total loan value each year.
** Keep in mind that PMI is an added cost. It’s an expense on top of your monthly mortgage payment.
Home Mortgage Types
Many first-time homebuyers find that they meet lender requirements in some areas, but not all. For example, you may have a good credit score but only a small down payment saved.
If you feel like you might not meet standard debt-to-income ratio, credit score, or down payment requirements, you can ask your lender about FHA or VA government-insured loans. Loans such as these offer more flexible requirements for qualified borrowers, and may be used along with certain down payment assistance programs if you qualify.
Work with your lender to determine the best mortgage type, program qualifications, and what you can afford amount.
After You’ve Set Your Budget
Once you determine a monthly mortgage payment you feel comfortable with, talk to a couple different lenders and use their estimates to go house hunting – it’s far better to know what your budget should be, rather than the potential of being turned down.
Six items included in a home payment:
- Payment of the principal
- Interest rate
- Estimated property taxes
- Insurance (collectively known as “PITI”)
- HOA fees (homeowner’s association)
- Private mortgage insurance (PMI)
Some ARM loans have low interest “teaser rates” for the first couple years. After the introductory period is over the interest rate and your monthly payment amount can double. Your lender should be able to steer clear of this – after all, it’s in their best interest that you not default.
And if a lender says you can afford more than what you want, you may want to stick with a smaller amount. Loans are typically 15- or 30-year mortgages – don’t get locked into a loan you’re unsure about.
Once you find the right lender and loan program, ask for a pre-approval. A pre-approval gives you a solid loan amount to show to sellers, so you can go into your house hunt with confidence.
When you’re looking to buy a home, keep in mind how much you can afford to spend without putting the rest of your financial plans on hold, so you can enjoy all the benefits of homeownership. This can help you build a stronger future—informed and equipped to succeed.