Are you planning to buy a house in this new age? Thinking about the unaffordable price tags? Then, we have good news for you! Neither you need a six-digit monthly income nor do you need to visit the lender to evaluate your credit score.
You can easily determine Income requirements using your debt-to-income ratio. According to the National Association of Realtors, the cost of an average house is about $341,600.
Even if you earn about $40,000 to $50,000; you can easily afford a medium-priced home. All you need is a good credit score and a minimum of 20% down payment.
If you’ve got a good credit score and a 20% down payment, you can easily afford a median-priced home with an income of just $46,500.
If you think the income you earn is the only deciding factor in buying a house, then you are wrong.
This article contains everything from how much home you can afford to the calculated income you need to buy a house.
Having a clear idea about how much home you can afford makes the home-buying process a lot easier.
Let’s find out!
Key Factors that Determine ‘How Much Home Can I afford?’
Sometimes, we have to pay unexpected bills in a medical emergency or overspend. It can take some time to understand how to calculate your monthly mortgage payments. Let’s look at some of the primary factors that strongly influence a lender’s decision on how much money they can lend you.
- Household income: it is the salary or income you earn on a regular basis via a job or other investments.
- Monthly debts & Expenses (Car loan/ Student loan payments, and others)
- Cash reserves/ Savings for a down payment.
- Credit Profile: It includes total debts and the credit score you owe.
All these above factors will help you determine the total amount you can borrow and the mortgage interest rate.
Know the 28/36 rule – Learn how it works
If you want to calculate ‘how much home can I afford,’ use this 28/36 rule of thumb. According to this affordability rule, the borrower must not spend more than 28% of their gross income including pre-tax, monthly income, and household expenses.
Also, they should have not spent 36% on total debts including mortgages, credit card bills, and car/student loans.
- Your monthly income is $5,500 a month.
- Debt payments are $500.
That means your monthly mortgage payment shouldn’t be more than $1,480.
The 28/36 rule is used by most mortgage lenders to check the financial situation of the borrower.
Income Requirements To Buy A Home
Your income is a baseline that defines how much monthly installment you can afford to pay every month. Buying a home is not as easy as it might seem to you. Keep in mind that mortgage Lenders have to look at various other parameters than only your paycheck or down payment. They’ll check whether or not you’re capable of paying the monthly installments. For example:
- The first and most important factor is your debt-to-income (DTI) ratio.
- How much do you earn on an annual basis?
- Size of your down payment.
- Your Credit Score.
Not sure whether you can get a mortgage on your present income? The basic step is to get pre-approved for the mortgage.
What is Pre-approval?
Well, it’s a letter that states you are eligible to borrow money from the mortgage lender. The amount of money you’ll receive as a mortgage may vary depending on the lender and your income.
In a nutshell, Pre-approval gives an estimate to lenders of how much home you can afford. Getting pre-approved enables you to start browsing for homes on sale, check their general prices, and find homes that fit your budget.
So, if you are a beginner, lenders will definitely consider your debt-to-income ratio and monthly income when you buy a new home.
How does the debt-to-income ratio impact affordability?
DTI is the most important parameter to measure the amount a lender will provide you. The thumb rule for DTI is simple. The lesser, the better!
It helps them decide whether you are ready or can afford the other debts. Generally, a borrower with a DTI of 50% or lower is approved for the mortgage.
But unfortunately, you won’t qualify for a mortgage if your DTI is higher than 50%. It reveals you have to focus more on increasing your income.
To obtain your DTI percentage, simply divide your total monthly recurring debts by your total monthly household income.
It includes evaluating your total monthly debts (such as your mortgage payments, insurance, car loans, student loan, and property tax to your monthly pre-tax income.
If you have a good to excellent credit score, there are better chances that you’ll be approved for a mortgage at a high ratio. Simply make sure, your house expenses aren’t exceeding 28% of your monthly income.
Let’s take an example:
- Your monthly mortgage payment ( including taxes and insurance)= $1,000/ month.
- Your monthly income ( before taxes) =$6,000.,
- Your DTI will be 16%. (1000 / 6000 = 0.167)
Pro tip: For future reference, save this process to calculate DTI.
Do you know what influences a lender the most? Well, it’s the fact that a borrower should have a consistent source of income. Though your salary is of major concern to lenders but is not the only parameter to calculate your income. There are other income sources as well including:
- Alimony payments
- Investment Income
- Social Security income
- Child support payments
- Military benefits and allowances
Let’s say you have included alimony payments as an income source and that would probably end in a year. Unfortunately, your lender won’t approve your loan.
Monthly Income sources may vary from person to person. For example, a borrower on payroll may need to submit documents like pay stubs and W-2s
Whereas, self-employed borrowers have to provide their tax returns and other required documents on the lender requests.
If you are looking to buy an expensive home, you’ll have to wait for a year or two in a high-paying position to get immediate approval from the lender.
Other Financial Considerations
Other than monthly income and DTI; there are two other financial factors you need to consider when buying a home.
- Your credit score
- The size of your down payment
Generally, a credit score of a borrower should range from 300 – 850. It reveals whether or not you qualify and are responsible for getting a mortgage.
The higher the better is the thumb rule for measuring your financial status using credit score. A high credit score reveals you are capable enough to pay your monthly installments on time. Also, there are no pending debts. The additional benefits are you’ll get lower interest rates from lenders.
Whereas a low credit score indicates your mismanagement and that you often overdraft on your accounts. Overall, the chances of getting a loan are almost nil. And, even if a lender will approve a loan, the interest rate will be comparatively much higher than conventional loans.
A high score you access to lower interest rates and more lender choices. If you have a low score, you may have trouble getting a loan.
For conventional loans, most lenders usually approve a credit score of 620 and above.
Is your credit score not up to the mark? Don’t worry! There are a few factors that you can work on to improve your score with time.
#1. Pay your debts on Time
Your payment history adds 35% while evaluating your credit score. So make sure to pay any outstanding debts and installments on time each month. If you don’t want to miss a due date, you can schedule automatic payments by consulting with your bank.
#2. Don’t close Lines of Credit
Closing credit lines can badly influence your credit score. Try to maintain your credit report, do not completely shut off your credit. Keep in mind another thing while buying a home that does not open your new credit lines. As it can lead to strict inquiries on your credit report.
#3. Size Of Down Payment
The down payment is the size of money you give to the lender. Not to forget the closing cost, which can be quite expensive. The down payment is expressed in percentages.
Usually, you have to pay a minimum of 20% down payment for conventional loans. The benefit is you don’t need to invest in private mortgage insurance.
You can use the mortgage calculator to determine how the down payment affects your monthly payment.
Please Note: You can even buy a home with a 3% down with a conventional loan, and a 3.5% FHA loan. If you are applying for VA or USDA loans, you can even buy a home with a 0% down payment.
What Percentage Of Income do I need to pay for a Mortgage?
Now talking about the main part of this guide i.e. how to get approved for a mortgage? What documents and proofs are required when applying for a home loan?
Also, what percentage of your monthly income do you need to keep aside for the mortgage?
As already explained in the 28/36 thumb rule, make sure you put a minimum of 28% or more to get easily qualified for the mortgage of your dream home.
A down payment of 20% means that you can easily pay $1200 per month for a mortgage. So as per the thumb rule of affordability, you need to earn at least $4,285 every month.
Additional Costs you need to pay when Buying A House:
While buying a house, monthly installments and down payment are not the only expenses, there are other costs also you need to know about including the closing costs.
Once the loan is approved, lenders charge an extra service fee( closing cost) for providing the services. Below are some of the closing costs you need to pay on finalizing the loan.
It includes the expenses of a professional appraiser’s report on your net home worth. Before lending the money, mortgage lenders need appraisals to make sure the house is worth the amount.
To avoid third-party claims on your home’s title; title insurance prevents both the lender and borrower from such scams. It is a one-time insurance fee that keeps you protected until you are the owner.
It is a loan processing fee charged by the lender.
In many US states, a real estate attorney is required to finalize the home title transfer. Generally, attorney fees can vary from state to state.
Starting from the closing date, a borrower needs to pay the property taxes till the end of the tax year. You simply need to pay a prorated share.
The closing costs also vary depending on your lender and state’s requirements. Usually, the borrower needs to pay 3% – 6% of their home buying price as the closing costs.
Let’s say, if the buying price is $150,000, then the approximate closing costs you need to pay can range anywhere between $4,500 to $9,000.
Frequently Asked Questions
Why it’s smart to follow the 28/36 rule?
Many mortgage lenders follow this home affordability 28/36 rule that acts as a baseline to find out the maximum monthly installments. As a thumb rule, it is suggested that a borrower should not spend more than 28% of their net income on household expenses. Also, they should not exceed spending 36% on total debt.
How does your credit score impact affordability?
The credit score is one of the major parameters that help evaluate the mortgage rate. The interest rate for a large down payment and a high credit score is usually low. In contrast with a low credit score, you’ll have to pay high mortgage interest plus insurance also.
How much home can I afford with the FHA loan?
Borrowers with a credit score of 500 or more, can easily apply for Federal Housing Agency loans with low down payments.
For example, for a credit score below 580, 10 % of a down payment is required. For a credit score higher than 580, you need to put down a 3.5% down payment.
How much house can I afford with a VA loan?
VA loan is supported by the U.S. Department of Veterans Affairs and is meant only for eligible active duty, retired service members, or their spouses. You can qualify for this loan with even less than a 20% down payment with no PMI needed.
How much house can I afford with a USDA loan?
The best part about USDA loans is the zero down payment requirement. You can easily buy a home with a USDA loan if you fall into the low to moderate-income category.
Is there any equation to determine if my income is enough?
Minimum required income per month = Monthly payment amount / Maximum housing DTI ratio. This is the formula you can use to find out if your income is enough to get approved by the mortgage lender. You can evaluate your estimated monthly income by simply using our mortgage calculator.
How to calculate the mortgage payment if there is a rapid change in income?
It’s obvious that with a change in your income, the maximum mortgage payment will also be affected. To determine the change, simply add up your gross monthly income and multiply it by the maximum housing DTI of your loan
No doubt, your income is the major factor that leaves a strong impact on the lender’s mind. But there are no set standards for income requirements when buying a home. As we already discussed in this article, income is the not only parameter to decide whether or not you qualify for a home. You also have to work on your DTI ratio, credit score, and down payment. They also equally contribute to getting qualified for a home loan.
To begin with, simply calculate the money you earn from different income sources including your job, investments, or others. Then check your monthly debts such as student loans, car payments, credit card bills, etc.
Getting pre-approved by the mortgage lender gives you an estimate of how much home you can afford. It’s a smart move to let mortgage lenders and home sellers know you are worthy of buying a home.
If you need any help, know how much home you can afford and the closing costs you need to pay. Contact USM Corporation!