How Much House Can I Afford?

By the Mercury Team

Buying a house is a cornerstone of the American dream, but it takes determination and careful planning to achieve this goal. One of the first steps in making this dream a reality is figuring out how much house you can afford. Let’s explore the key factors to consider when creating your home-buying budget, determine an estimated monthly payment, and review the different types of housing loans available.

Factors That Determine ‘How Much House Can I Afford?’

Numerous factors can influence your housing affordability, including:

Annual Gross Income

Your annual gross income is the total amount of money you earn in a year before taxes and other deductions are taken out. Lenders typically use this information to determine your loan amount.

Monthly Debt Payments

Monthly debt payments include expenses like car payments, student loans, credit card payments, rent, mortgages on other properties, and other debt obligations. You want to try to minimize debt as much as possible because the more debt you have, the higher your debt-to-income (DTI) ratio will be.

Debt-to-Income Ratio

What is a debt-to-income ratio? This ratio compares your monthly debt payments to your gross monthly income. Lenders use it to assess your financial health. You want a low DTI ratio because it tells the lender that you strike an ideal balance between your income and debt, making you a less risky borrower. On the other hand, a high DTI ratio indicates to lenders that you allocate a large portion of your monthly income to paying off debts, making it harder to qualify for a mortgage.

Down Payment

What is a down payment? It’s the amount of money you pay upfront when buying a home. Consider it a deposit that shows your commitment to purchasing a home. The size of your down payment can impact your mortgage payments, loan terms, and overall affordability.

A good rule of thumb is to put down 20% of the home’s purchase price. This can help lower your monthly mortgage payment and avoid private mortgage insurance (PMI), which protects lenders if you default. Lower down payments usually mean higher loan amounts, which can lead to increased monthly payments and potentially less favorable loan terms.

Terms (Years)

A term is the time range of a loan. The most common terms are 15-year and 30-year loans. A 15-year mortgage typically has higher monthly payments but allows you to pay off your loan faster and pay less interest over the loan’s lifespan. Conversely, a 30-year mortgage has lower monthly payments, making it more affordable on a month-to-month basis, but you’ll pay more in interest over time.

Interest Rate

An interest rate is the percentage you pay to borrow money. Lenders typically look at these factors to help calculate your interest rate:

• Income
• Size of down payment
• Credit score
• Type of loan you choose
• Current market conditions

Lower interest rates result in decreased monthly payments and less overall interest, making the loan more affordable. On the other hand, higher interest rates increase both your monthly payment and the total interest cost.

What Is an Estimated Monthly Payment?

An estimated monthly payment gives you a more comprehensive view of your potential housing costs beyond just the mortgage. It’s made up of several components and each contributes to the total amount you’ll need to budget each month.

The Principal

When you borrow money to buy your home, the amount you borrow is called the principal. For example, if you take out a $300,000 loan, that’s your principal. Each month, a portion of your payment goes towards paying down this principal, slowly reducing the amount you owe over time.

The Interest

As mentioned before, the interest is the cost of borrowing money. It’s expressed as a percentage of the principal, which is what the lender charges you for the loan. This interest is divided into monthly payments, so a chunk of your monthly payment will always go towards covering this interest. For instance, if you have a $200,000 loan at a 4% interest rate for a 30-year term, your monthly payment (excluding taxes and insurance) would be approximately $955.

Homeowners Insurance

Homeowners insurance financially protects you against various risks like fire, theft, or natural disasters. Most lenders require you to have homeowners insurance, which they often include in your monthly mortgage payment. So, what does homeowners insurance cover? Generally, it covers damage to your home’s structure, your personal belongings inside the home, and liability protection in case someone gets injured on your property. This ensures you’re always covered and your lender’s investment is protected.

Property Taxes

Property taxes are ongoing fees you pay to your local government to fund public services such as schools and roads. The amount you pay is based on your home\s value, which the government assesses yearly. Fortunately, property taxes are typically divided into monthly payments and included in your mortgage payment. This way, you don’t have to worry about a large tax bill once a year.

Types of Housing Loans

Choosing the right type of housing loan can help determine your mortgage affordability. Here are some loans to consider:

Fixed-Rate Mortgages (FRM)

With a fixed-rate mortgage, the interest rate remains unchanged throughout the loan term. This stability makes it easier to budget and plan for the future because you know your payment won't change over time. However, if you purchase your home when interest rates are high, you could be locked into that rate unless you choose to refinance in the future.

Adjustable-Rate Mortgages (ARM)

Unlike fixed-rate mortgages, adjustable-rate mortgages have interest rates that can change periodically. ARMs often start with a lower introductory interest rate compared to FRMs, which can be appealing if you’re looking to save money initially. However, your payments may increase or decrease based on market conditions, making it more challenging to predict long-term costs.

Conventional Mortgages

Conventional mortgages are loans that aren’t guaranteed or insured by the government, and they’re available through private lenders like banks, credit unions, and mortgage companies. They come in two main types: conforming loans, which meet the guidelines set by the Federal Housing Finance Agency (FHFA), and non-conforming loans, which don’t meet those guidelines.

To qualify for a conventional mortgage, you’ll typically need a minimum credit score of 620. These loans also usually require a down payment of at least 3%, though 20% is recommended to avoid private mortgage insurance (PMI). They’re a popular choice for many homebuyers because they can offer competitive interest rates and flexible terms.

Government-Backed Mortgages

As the name suggests, the government provides loans to help specific groups of people who want to become homeowners. These include:

• FHA loans: What is an FHA loan? The Federal Housing Administration (FHA) offers mortgage options with lower down payment requirements and more lenient qualification standards. This loan can be a great option for first-time homebuyers, people with low credit scores, or individuals who can’t commit to a large down payment.
• VA loans: What is a VA loan? VA loans are backed by the Department of Veterans Affairs (VA) and are available to veterans, active-duty service members, and eligible spouses. They often require no down payment and offer favorable terms.
• USDA loans: These loans are backed by the U.S. Department of Agriculture (USDA) and are designed for rural homebuyers. They may offer zero down payment options and competitive interest rates.

Jumbo mortgages

Jumbo mortgages are for loan amounts that exceed the conforming loan limits. These loans are used to finance luxury homes or properties in high-cost areas. Since they involve larger sums of money, jumbo mortgages often have stricter credit requirements and higher down payments.

Conclusion

Buying a home is one of the biggest decisions you’ll make in your lifetime, so take the time to carefully consider your options. To help ensure you’re headed in the right direction, consider working with a financial advisor or mortgage professional who can provide personalized guidance based on your situation.

While you want to secure the right mortgage, protecting your investment with best-in-class homeowners insurance is equally important. Look no further than Mercury, where we offer comprehensive, low-cost home insurance plans to safeguard your new home against unexpected events.

Contact us today for a fast, free quote!