Buying a House You Can Afford: Loan Approval & Budget Factors

A house built out of money

What this article is all about:



Determining Your Real Estate Price Range

If you're reading this article, you're probably thinking about purchasing a home and wondering, "How much can I afford to spend on a house?" Determining a realistic price range upfront helps your real estate agent identify viable properties and sets you up to successfully manage the mortgage approval process, in addition to preventing the disappointment of falling in love with a home you can't afford.

We're going to explore the two key dimensions that determine how much house you can afford: 1) what a mortgage lender will loan you, and 2) how much you can actually spend each month after considering all of your expenses. Taking both of these dimensions into account will give you a solid picture of your real estate price range and put you on the path to happy homeownership.

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What Size Home Loan Can I Qualify For?

Most homebuyers will require some form of financing to make the purchase. Understanding what size loan you might be eligible for, and the costs associated with that loan, is an important first step in identifying how much house you can afford.

Loan approval factors

Mortgage lenders review several factors to determine if you qualify for a home loan and, if so, what amount and interest rate to offer you. The specific requirements vary by lender, loan product, and program, but let's take a look at the most common aspects of your financial health that will be under inspection.

Income

A mortgage lender will review your annual income before taxes as well as the income of your co-borrower, if applicable. This could include: any employment income, including base pay, bonuses, commissions and tips; social security or other retirement income; rental property income; investment income such as dividends and interest.

Presenting all forms of income for consideration often increases your likelihood of receiving a loan approval, but be aware that you might be required to provide documentation like recent pay stubs, W-2s, or tax returns proving any income claimed. Additional documentation is often required for variable income like bonuses or tips so that lenders can understand how this income has trended over time.

Debt

Your current financial obligations are taken into consideration when determining your mortgage qualification. From a lender's perspective, this includes liabilities like outstanding loans (car, student, or other personal loans), required alimony or child support payments, and credit card debt. Credit card balances that are paid in full each month, home expenses like utilities and maintenance, and other routine costs like gas and groceries do not count as debt in the eyes of a lender.

Credit history

The three major credit bureaus, Equifax, Experian, and TransUnion, track additional information that mortgage lenders use to determine your creditworthiness. This credit report includes:





The information contained in your credit report is used to calculate a credit score. The most popular calculation is one created by Fair Isaac Corporation (FICO). FICO Scores range from 300 to 850 – the higher the better – and help mortgage lenders evaluate the information contained in your credit report. Exact credit score requirements depend on the type of mortgage you are seeking.

Applicants with higher credit scores are typically offered more favorable loan terms. When obtaining a mortgage with a co-borrower, some lenders are required to focus on the lower of the two scores to determine loan approval and rates. Get a personalized mortgage quote to see potential loan options based on your particular credit profile.

Assets

Mortgage lenders will ask for proof of current assets, including money in checking and savings accounts, stocks, bonds, and life insurance policies. This evaluation is meant to ensure funds are available for a down payment as well as other upfront transaction costs. Lenders are also looking for capital that can help repay the loan in the event your regular income is temporarily disrupted, for example in the event of job loss.

Estimating your home loan amount

The total home loan for which you could qualify heavily depends on the amount a lender determines is your maximum monthly payment. The primary calculation mortgage lenders use to determine your maximum monthly payment is called the debt to income ratio (DTI). This ratio captures the percent of your monthly gross income that is spent on financial liabilities like a mortgage and lenders aim for certain thresholds to ensure a borrower’s ability to repay the loan. You can learn more about DTI and how to calculate yours in our article on mortgage payments.

In addition to paying off a portion of the mortgage principal each month, your maximum monthly payment must also take into account the cost of fees like loan interest, local property taxes, and mortgage insurance if applicable. Homeowner's Association (HOA) dues are included in the debt to income ratio calculation, though they are typically not part of your actual mortgage payment.

These fees, along with the term of your loan, impact the amount of your total loan approval – and therefore the maximum home purchase price you can afford – since only a portion of your monthly maximum is available to pay down the loan principal.

This calculator gives you a quick estimate of how much you could be approved for based on standard lender DTI guidelines and average mortgage, property tax, and insurance rates. However, given the dependence on the fees mentioned above you might find it helpful to get pre-qualified for a loan by a lender who is familiar with your local tax rates and average HOA costs.

Pre-qualification is a free estimate of how much a lender would be willing to loan you based on information you provide about your income, debts, and down payment. The process is meant to be quick and easy, and does not require proof of income or assets. Pre-qualifying with a lender does not require you to proceed with a formal mortgage application, nor does it imply that the lender will approve you for a loan. It is simply a rough estimate to assist you in determining a realistic price range.

Getting pre-approved for a mortgage

Serious home shoppers should consider getting pre-approved for a loan. More formal than pre-qualification, pre-approval involves an in-depth review of your finances and credit history. You typically complete a pre-approval application and submit documents that prove your recent income and current assets. An application fee may apply; check with your lender.

At the conclusion of the pre-approval process you will receive a good faith estimate from your mortgage lender. This estimate, which is usually good for 60-90 days, indicates the loan amount and interest rate for which you would likely be approved assuming nothing in your financial situation changes. Getting pre-approved by multiple lenders will allow you to compare rates and other loan terms to get the best offer. You can also house shop with confidence, knowing the loan terms you will likely receive.

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How Much Should I Spend on a House?

So you've read all about the home loan process and even got pre-approved by a lender. You're ready to buy, right?

Not so fast. Mortgage lenders only look at a portion of your financial commitments when qualifying you for a loan. While regulations exist to protect you from taking on a mortgage you can't afford, it's possible for your home purchase to have unexpected impacts on the rest of your household budget.

Before buying a home, take a good look at all of your anticipated expenses. If the mortgage payment you were quoted doesn't leave enough cash for everything else, calculate the payment amount you can afford and adjust your real estate price range accordingly. Borrowing less is the quickest and easiest way to decrease your monthly mortgage obligation.

Affordability considerations

Household obligations

If you are currently renting or living in a smaller house, your new home purchase may increase your general household costs. Be sure to account for the following expenses in your monthly budget:







Other significant expenses

Make sure your monthly mortgage payment leaves room for major current and future expenses. This could include childcare, school tuition, and medical bills, among others.

Financial goals

Do you have goals in addition to purchasing a home that require a financial commitment? If you plan to save for retirement, college, or just a rainy day fund during the tenure of your home loan, incorporate these costs into your monthly budget.

Lifestyle preferences

While purchasing a house is usually an exciting occasion, over-spending can leave you disappointed or worse – in fear of defaulting on your home loan. The term "house poor" describes a person who spends a large proportion of his or her income on home ownership, leaving little money for discretionary expenses. Consider factoring in the cost of things like clothes shopping, hobbies, or travel when estimating your ideal monthly mortgage payment.

Calculating your price range based on preferred monthly payment

If you're looking to spend less than your loan approval amount, use this formula to estimate your target home price based on your ideal monthly payment, anticipated down payment, APR and loan term.

Target Home Price = d + (((1 - (1 + i)^-n) * p) ÷ i)

d = down payment, in dollars
For example: $15,000

i = annual interest rate divided by payments per year
For example, a 6% APR with monthly payments: 0.06 ÷ 12 = 0.005

n = total number of payments you will make on loan
For example, a 30-year loan with monthly payments: 30 * 12 = 360

p = ideal monthly payment, in dollars
For example: $1,000

Example Calculation:
A $1,000 monthly payment at 6% APR for 30 years with $15,000 down payment

$181,791.61 = $15,000 + (((1 - (1 + 0.005)^-360) * $1,000) ÷ 0.005)

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Making the Most of Your Monthly Payment

These tips can maximize your buying power without breaking the bank.

Save up for a big down payment

Your down payment plays a significant role in securing a home loan and determining how much house you can afford. Increasing the amount of your down payment can help you purchase a more expensive home or reduce your monthly mortgage obligation. Consider the following:




Pay down existing debt

We've mentioned that lenders use your debt to income ratio (DTI) to determine the maximum total amount they will lend you. Did you know your DTI also influences the mortgage terms you qualify for, including APR? Borrowers with a lower debt to income ratio are seen as less risky since a larger portion of their monthly income is available for covering the cost of home ownership.

Lowering your DTI can result in a better rate approval, potentially reducing your monthly payment and saving you a lot of money in the long run. If you currently have a large amount of debt relative to your income, consider paying down those liabilities before seeking a new home loan. Always consult with a licensed financial professional prior to making any moves that could impact your credit history or financial solvency.

Check your credit report

Before applying for a mortgage, you should obtain a copy of your credit report from each of the major bureaus and ensure the history they've captured is accurate. Removing any erroneous entries in your credit report could increase your credit score and improve a lender's evaluation of your mortgage application. It's important to review all three because the details and scores they report can be different. You are entitled to one free report from each national reporting company annually.

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Resource center & glossary

Key terms - in plain English

Annual Percentage Rate (APR) - Interest that is calculated annually, based on the principal balance of the loan.

Borrower - The person, or entity, that is requesting the loan.

Debt-to-Income Ratio - The relative proportion of your debt compared to your monthly gross income.

Down Payment - A payment that reduces the principal value of the loan made during a home purchase.

Form W-2 - A tax form issued annually by employers stating how much an employee was paid that year.

Gross Income - Your monthly income, before taxes and deductions.

HOA - Homeowners Association. Common in condominium and townhome developments, but not exclusive to them. Usually collect a monthly due to maintain common areas, property facades, and similar.

Lender - The bank, or financial institution, that is issuing the loan.

Loan Principal - The initial amount borrowed from the lender to secure the home purchase.

Preapproval - The rigorous process whereby a lender provides a contingent loan approval, based on a thorough evaluation and verification of the borrower's current credentials.

Prequalification - The simple process whereby a lender estimates the maximum loan a borrower could receive, based on a brief analysis of figures provided by the borrower.

Repayment Term - The number of years, or months, required to repay the full amount of a loan, including total interest payments due.

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