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Reader question: “I am trying to figure out how much house I can qualify for with my current salary of around $75,000 per year. I have been reading up on the different ways to calculate this, but everyone says something different. I guess what I really need to know is how do lenders determine how much house I can afford? Do they use some kind of income formula, like a certain percentage of my income?”
Whether you intended to or not, you’ve actually posed two separate questions:
So there are two numbers you should be concerned with. The first number is your own monthly housing budget, which you should determine for yourself (without a lender’s involvement). The second number is the mortgage amount you can qualify for, given your current income and debt situation.
The first and most important number comes from you. The second number comes from the lender. It’s important to make this distinction, because it’s primarily your responsibility to buy a house you can actually afford.
- Affordability: To figure out how much you can realistically afford, you must consider your net income, your recurring monthly expenses, and your financial goals (explained below).
- Qualifying: The bank will primarily use your debt-to-income ratio to determine how much house they are willing to lend (see below).
These are two different numbers and two different processes. So let’s address them separately, starting with question #1…
How Much House Can I Afford to Buy?
Before you start talking to lenders, you should already know what you can afford to spend on a monthly house payment. This is known as your housing budget. Here’s how to measure it:
1. Start with your net monthly income.
To determine how much house you can afford on your current salary, start with your net monthly income. This is your “take-home” pay, after taxes have been withheld. Write this number down on a piece of paper, because it’s the total sum you have available each month. If you are married, and both you and your spouse will contribute to the mortgage payments, write down your combined household income.
2. Subtract non-housing monthly expenses and savings.
Next, you’ll start chipping away at the amount from step 1 by subtracting monthly expenses. This includes car payments and insurance, credit card payments, health care costs, groceries, savings and retirement plan, etc. Don’t forget to account for quality-of-life items, such as the occasional dinner out, movies, and the like. If you’re currently renting, you can leave that monthly expense off the list, since you won’t have any rent payments after buying a house. You are focusing on non-housing expenses here.
3. Use a mortgage calculator to get the maximum house price.
Next, subtract your total monthly expenditures (step 2) from your net monthly income (step 1). The amount you are left with is what you could potentially put toward a mortgage payment.
So, how much house will this get you? To answer this question, you’ll need to use a mortgage calculator. You can find plenty of them online. Just about every bank website has a home loan calculator.
If you haven’t started house hunting, you might not know where to start in terms of the price. That’s okay. You don’t need the list price for a specific home at this point. You’re just trying to get a rough idea of how much house you can afford to buy, based on the monthly budget you came up with in previous steps. Just plug in some hypothetical sale prices to see how much the monthly payments would be. You’ll quickly learn what you can afford — and what you can’t.
4. Don’t forget your emergency fund.
When setting your housing budget, remember to leave some money left over each month for investing and/or savings. Financial experts also recommend keeping an “emergency fund” in the bank. This is money that could be used in the event of a job loss or other financial setback. How much should you keep in reserve? That depends on who you ask.
Paul Golden, spokesman for the National Endowment for Financial Education, says three to six months worth of living expenses is a good place to start. He recommends an even larger emergency fund during a recession, or times when the job market is weak.
Other experts recommend keeping more money in reserve. Mitchell D. Weiss, a finance professor at the University of Hartford, recommends keeping six to twelve months worth of expenses in your emergency-fund bank account.
Bottom line: “How much house can I afford to buy?” is only half of the question. What you should really be asking is, “How much of a home can I purchase while also maintaining a reasonable quality of life and savings-account contributions?” This is where your budgeting starts.
Lenders Will Qualify You Based on Debt and Income
Once you have a housing budget on paper, you can move on to question #2: “How much of a loan can I qualify for, based on my income?” Here’s how banks, mortgage companies, and other lenders determine how much they are willing to lend to borrowers…
The debt-to-income ratio is key.
The first concept you need to understand is the debt-to-income ratio, or DTI. As you can probably guess, this is a numerical comparison between the amount of money you earn (income), and the amount you spend each month on recurring expenses (debt). It is usually written as a percentage. For example, a ratio of 33% shows that about one-third of my income is going toward my monthly debts.
There are two different types of debt-to-income ratios:
- The front-end DTI is also known as the housing ratio, because it only considers your housing-related debts (mortgage payment, property taxes, etc.).
- The back-end DTI is also referred to as your total ratio, because it considers all of your monthly recurring debts (housing payment in addition to credit cards, personal loans, etc.).
By the way, lenders typically use your gross monthly income when calculating these numbers, as opposed to your net.
These days, many lenders are limiting borrowers to having a back-end (total) debt ratio no greater than 43%. That’s because the federal government’s Qualified Mortgage rule, which took effect in January 2014, limits borrowers to 43% DTI. This number is not set in stone — some lenders will allow higher ratios for otherwise strong borrowers. It’s just an industry-wide trend you should know about.
So let’s assume the bank does limit you to 43% on the back end. That means your total monthly debt cost should not exceed 43% of your gross monthly income. You can do the math from here, to determine how much house you might qualify for under this kind of standard.
If you do the math and find out that your back-end DTI is well over 43%, you might have trouble getting approved for a loan. If it’s in that range or below, then your debt load probably won’t raise any red flags with lenders. Again, this number is not set in stone. But it is a commonly used threshold for underwriting and approval.
Disclaimer: This article answers two common questions asked by home buyers: (1) How much house can I afford with my salary? (2) How much will the lender qualify me for? Please note that these are generic scenarios that may not apply to your situation. Every lending scenario is different, because every borrower is different. The only way to find out if you can qualify for financing is to apply. This information has been provided for educational purposes only and does not constitute financial advice or guidance.