What Size Mortgage Can I Afford? Factors to Consider When Determining Your Budget
Updated: Feb 23
Buying a home is a significant investment, and choosing the right mortgage is crucial. The size of your mortgage is a critical factor in determining the affordability of your home, and it's essential to understand what you can afford before you start shopping for a property. In this guide, we break down the factors that affect your affordability and provide helpful tips for making a smart decision.
Before we dive into the details, let's define what we mean by "mortgage affordability." It's the amount of money you can borrow from a lender to purchase a home without putting undue financial strain on your budget. Determining what size mortgage you can afford is critical because if you take on too much debt, you risk defaulting on your loan, which can have serious consequences for your credit score and financial future.
Loan defaults, and bad loans made by banks, are the critical factors that led to the 2008 financial crisis. Since that time, banks have become significantly more stringent regarding the income requirements a person must have in order to purchase a home.
How Lenders Determine Your Mortgage Affordability
Lenders use several factors to determine your mortgage affordability, including:
Debt-to-Income Ratio (DTI): Your DTI ratio compares your monthly debt payments to your gross monthly income (this is your income before taxes are taken out). A lower DTI ratio indicates a lower risk to the lender, and you may be able to qualify for a larger mortgage. In my discussions with loan officers, they don't like to provide loans when your DTI is above 35%.
Loan-to-Value Ratio (LTV): Your LTV ratio compares the loan amount to the appraised value of the property you want to purchase. A lower LTV ratio can result in lower interest rates and better loan terms. If you can find a deal on a house then your LTV will be in a good position.
Credit Score: Your credit score is a critical factor in determining your mortgage affordability. A higher credit score can result in better loan terms and lower interest rates. Credit scores have different ranges depending on which credit bureau you ask. Typically they break out like this:
300-629 is bad
630-689 is fair
690-719 if good
720 and above is excellent
If you have excellent credit, then a lender might be a bit more flexible on some of the other numbers we talk about in this section.
Employment History: Your employment history can impact your mortgage affordability, as lenders prefer borrowers with a stable work history and steady income. Keep a consistent work history and you are more likely to get a mortgage. This doesn't mean staying at the same job for 10 years, it means staying employed for every day of the past 10 years (10 years is simply an example).
Factors That Affect Your Affordability
Several factors affect your mortgage affordability, including:
Income: Your income is a critical factor in determining how much mortgage you can afford. The more you earn, the more you can borrow. In our example of DTI above, if you have a gross income of $100k annually, then the amount of money you can borrow would be higher than if you are making $50k annually.
Monthly Expenses: Your monthly expenses, including car payments, credit card bills, and other debts, will impact your mortgage affordability. The higher your monthly expenses, the less you can borrow. With the income example above, if you are making $100k annually and have $70k in expenses vs the other person making $50k annually that might only have $10k in expenses. In this case, the person making $50k has a better DTI because they have kept their monthly expenses quite low.
Down Payment: This one is pretty basic, a larger down payment can result in a smaller mortgage and lower monthly payments. Lower monthly payments mean your income can be lower and your expenses can be higher.
Interest Rates: Interest rates can impact your mortgage affordability, as higher interest rates result in higher monthly payments. We have all learned through the end of 2022 and into 2023 that interest rates are a critical factor in home affordability.
Loan Term: The length of your loan term can impact your mortgage affordability, as longer terms result in lower monthly payments but higher interest costs over time.
Tips for Making a Smart Mortgage Decision
Here are some tips for making a smart mortgage decision:
Set a budget and stick to it: Determine how much you can afford to spend on a home, including your down payment, closing costs, and ongoing expenses like property taxes and homeowners insurance. Stick to your budget to avoid overextending yourself financially.
Don't overextend yourself financially: Just because you can qualify for a larger mortgage doesn't mean you should. Be realistic about your budget and don't take on more debt than you can comfortably manage.
Consider all of the costs associated with owning a home: In addition to your mortgage payment, owning a home comes with other expenses, including property taxes, homeowners insurance, maintenance, and repairs. Make sure you factor these costs into your budget.
Get pre-approved for a mortgage: Getting pre-approved for a mortgage can help you determine how much you can afford to borrow and give you an advantage when shopping for a property.
Work with a trusted real estate agent: A trusted real estate agent can help you navigate the home-buying process, negotiate with sellers, and find a property that meets your needs and budget.
By considering these factors and working with a lender, you can get a better idea of what size mortgage you can afford. It's important to be realistic and not stretch your budget too thin, as you'll also need to consider ongoing expenses such as maintenance and repairs.
In summary, determining what size mortgage you can afford requires a careful review of your income, debts, down payment, credit score, and local housing market. By considering these factors, you can make a more informed decision about the size of the mortgage that's right for you.