Are you making big plans to buy a new home? Or setting goals to buy a new home in the future?
There are plenty of tools online to help you figure out how much home you CAN afford, but have you asked how much home you SHOULD afford?
With 3 different ways to calculate mortgage affordability, let me help guide you through each method- and which one you should be using to find the best mortgage for your budget.
Mortgage Affordability Method #1: Ballpark Method
The ballpark method for mortgage affordability is the easiest and simplest.
Simply take your total gross income or salary (pre-tax) for one year. If you’re applying for a mortgage with a partner, make sure you add your incomes together.
Now multiply that by 2.5 or 3.
And you’re done!
So let’s say that you have a salary of $60,000.
That would mean an affordable home would be in the $150,000-$180,000 range.
The beauty of the ballpark method is also its downfall.
While it’s super simple, it’s too simple to capture your entire financial situation- but it’s a good spot to start.
Let’s dig a little deeper.
Mortgage Affordability Method #2: Debt-to-Income Method
Your lender will determine your mortgage affordability with a more complex method.
Like the ballpark method, take your total gross income or salary (pre-tax) for one year. If you’re applying for a mortgage with a partner, make sure you add your incomes together.
Then this method gets a little more complex.
Based on your credit score, your lender pulls ALL of your debt payments into one sum for your total debt payments.
To build your debt-to-income ratio, simply divide your total debt payments by your total gross income.
For example, if you make the same $60,000 ($5,000 per month) as before, but you have $1,000 in minimum debt payments every month, your monthly debt-to-income ratio is $1,000/$5,000, or 20%.
Your lender’s goal is that this debt-to-income ratio never goes above 43%.
In my example, this means that your total debt payments for the year can never go above 43% of $60,000, or $25,800 per year ($2,150 per month).
This means that your total monthly mortgage cost (principal, interest, taxes, and insurance) can never go above $2,150 – $1,000, or $1,250 per month.
If your total expected payment is higher than $1,250 per month, you will have to either increase your income or decrease your debt to adjust your debt-to-income ratio.
While the debt-to-income ratio is a solid metric for determining mortgage affordability, it doesn’t take your other regular expenses and lifestyle into account.
Lenders are also going to factor in your credit score into your interest rate, so don’t forget to clean it up before you apply for a mortgage, too. Check out my Level Up guide to your credit score to help you with this step.
Let’s try one more method.
Mortgage Affordability Method #3: The Right Method for YOU
In order to calculate the mortgage you can actually afford, you need to factor in YOUR life and regular expenses- not just your consumer debt.
The best method to get a full picture of your income and expenses is to build a budget.
Start with your regular take home pay. Don’t include bonuses or overtime in this calculation- focus on your consistent income.
If you have a job with inconsistent income, look at your paystubs for the last few months and take the average.
Add up all of your regular expenses, then remove all of the ones related to your current living situation.
If you’re currently paying rent or a mortgage, remove that line. Same for any existing renter’s or home insurance and utilities.
How much money do you have leftover at the end of the month?
But let’s not stop there.
How much do you NEED leftover at the end of the month? Take that amount out first.
What expenses will you have to cover in the home?
Expect to pay 1-4% of the home’s value in repairs each year, plus you’ll need to start saving for major repairs like a roof and HVAC updates.
Call utility companies to ask about estimated cost for a specific property- but remember it’s only an estimate and could be low or high depending on the current owner.
Take all of those homeownership costs out of your remaining budget.
Now how much can you afford?
There’s YOUR number.
What Do You Do If These Numbers Weren’t What You Expected?
You’ve run the ballpark method to know approximately where to start.
And you’ve run the lender’s method to know what your lender will tell you that you can afford.
Then you figured out what your budget will actually allow
But what do you do if these numbers don’t match your dream house?
There are a few adjustments that you can make- but remember that these steps take time!
Option 1: Pay Down Your Debt
The best way to decrease your debt-to-income ratio is to pay down your debt. Paying down your debt also opens up room in your budget for what you can afford.
Option 2: Raise Your Income
You can also decrease your debt-to-income ratio if you can find a way to increase your regular income by getting a new or second job, taking on a side hustle, or seeking a raise in your existing role.
Option 3: Raise Your Credit Score
If you can raise your credit score, you might be able to get a lower interest rate on your mortgage. A lower interest rate decreases your monthly payment and makes your mortgage more affordable.
Option 4: Look Into Mortgage Affordability and Loan Assistance Programs
Many lenders offer grants for closing costs and down payments. Make sure you talk to your lender about these opportunities, especially if you’re a first time home buyer.
There are also mortgages with down payments starting at 3%. Watch the fine print on these mortgages, as they usually require Private Mortgage Insurance (PMI), an additional cost added to your monthly payment (about .5-1% of your mortgage annually).