12 Steps to buying a Home, Step 3
As you set out on your home search, it is important to know the following:
- What kind of home you want and can afford
- How much your monthly payments will be
- How much you need to save for a down payment
View affordability from two perspectives:
- Your overall monthly payments which included household expenses, mortgage payment, home insurance, property taxes, auto loans and any other financial considerations
- How lenders determine what you can afford. Just like lenders, our Affordability Calculator looks at your Debt-to-Income Ratio (DTI) to determine what home price you can afford.
Know these terms and how they work
- Debt-to-Income (DTI) identifies the percentage of your gross monthly income (the amount you earn before tax) that goes towards your monthly debts. Your monthly debt is the sum total of all your recurring payments such as personal loans, auto loans, student loans, credit card payments, child support, and any other expenses that you would find on your credit report. This does not include mortgage payments, rent or regular expenses like food, transportation and utilities. It is very important to provide your monthly debt and annual income amounts accurately to estimate your DTI.
- Your DTI is estimated by dividing your total monthly debt by your gross monthly income.
- Monthly debt / gross monthly income = DTI %
- Generally, DTI is displayed as a range of 20% to 50% and reflects an estimate of the top and bottom of your affordability. This range will help you figure out what you can afford and also helps lenders determine your approval status for a mortgage loan.
- A DTI score of 36% or less is often regarded as affordable by lenders – hence a range that we recommend. Lenders frequently consider the higher your DTI, the more difficult it will be to make your monthly payments. Generally, the lower your DTI, the greater probability you will have of qualifying for a loan.
- See below for estimated DTI percentages and how they relate in terms of your budget (what you can afford in monthly payments based on the information you have provided).
20-27%. Quite affordable with your budget
28-36%. Affordable with your budget
37-43%. Stretching your budget thin
44-50%. Very tough with your budget
Annual household income & monthly expenses
Annual household income
This includes the entire amount you and your co-borrower earn, including salary, wages, tips, commission, and any other regular income, such as rental income, before taxes.
Your current monthly expenses are a key factor in determining how much you have available to spend on a mortgage. Take an account of all your monthly expenses. We recommend that you include all your monthly payments, such as auto loan payments, student loan payments, minimum credit-card payments, insurance, utilities, telephone bills, subscriptions, and groceries. It is also wise to include the amount you typically set aside for savings for an accurate estimate of your monthly expenses.
Down payment & credit score
This is the amount you pay upfront toward your home purchase. Typically, the recommended amount is 20% of your purchase price. Under certain loan programs, a down payment amount may be as low as 3.5%. If you have served in the military, you may even be eligible for a down payment of 0%. The down payment you make will determine how much your monthly payment will be. You should take into consideration your financial situation and your financial plan, to figure out a down payment that best suits your circumstances. Check out our Mortgage Guide for the lowdown on down payments.
Your credit score is calculated by one of the three credit bureau services: Experian, TransUnion, and Equifax. This score is one of the main things that lenders assess in order to determine what loan options, mortgage rates and mortgage terms they can offer you. A higher credit score is favored by lenders, because it suggests that a borrower is less likely to default on the mortgage. It is always a good idea to monitor your credit report and to ensure that it is in good standing. To find out what a good credit score is, and to learn how credit scores are calculated, check out our Mortgage Guide.
Mortgage rates, payment, & loan type
- Mortgage rates are the rate of interest that is charged on a mortgage. Lenders determine the mortgage rates in most cases. Rates are fixed or variable, meaning that they either remain the same for the duration of the mortgage or vary depending on a benchmark interest rate. Mortgage rates are directly related to interest rates, and a rise or fall in interest rates will result in a rise or fall in mortgage rates.
- In addition to the interest rate, several other factors determine the specific mortgage rate that a buyer will qualify for. Your location affects your mortgage rate, and may vary from 0.25% to 0.5% between lenders on any given day, depending on local laws, the competition for lenders, fees, and closing costs. Your credit score is another important factor in determining your mortgage rate. If you have a poor credit score, you may only qualify for a higher mortgage rate, because a lender can recoup most of the loan amount at a faster rate if the rate is higher. Borrowers with higher credit scores may qualify for a lower rate, because the risk that they may default on the loan is considered to be lower.
- It is highly recommended that you obtain loan pre-approval when shopping for a home, so that you can put in an offer and subsequently lock in the rate for your home loan.
Monthly mortgage payment
- We calculate your monthly mortgage payment based on the loan amount, interest rate, and the amount of your down payment. This payment includes principal and interest. In some situations, lenders may require you to create an impound account, which means that your monthly mortgage payment will include payments for property tax and insurance. If your down payment is less than 20%, you may be required to add private mortgage insurance (PMI).
- When a bank evaluates your loan application, it looks at your current income and debt. However, your complete financial picture may include other considerations. It is your responsibility to take into account all your monthly expenses and any projected expenses, and to add these to the estimated monthly mortgage payment, if you want to ensure that you will be comfortable paying the mortgage you are being offered. It is also recommended that you include in your budget 1% of your property’s value, to pay for home maintenance and repairs.
- Lenders offer different loan programs. Common types of loan include 30-year fixed, 15-year fixed, and 5-year adjustable-rate mortgages (ARM). Your monthly mortgage payment will vary depending on the loan program you choose. You should compare and contrast different programs, to see which is most appropriate for your situation. A fixed-rate loan, such as a 30-year fixed-rate loan, will have a fixed rate for 30 years, or for as long as you own the property. Such programs are best suited to buyers who plan to stay for a considerable period and prefer to lock in a rate for the long term. A 5/1 ARM loan typically offers a lower rate than a 30-year fixed mortgage, but the rate is fixed only for the first five years of the loan term. Check out our Mortgage Guide to learn more about the pros and cons of different types of mortgages. It is important to discuss your loan options with your lender, to decide which option best suits your situation.
Annual property tax & APR (%)
Annual property tax
- Annual property tax is a tax that you pay to your county, typically in two installments each year. The amount of the property tax varies depending on where you live, and is usually calculated as a percentage of your property’s value. When you buy a home, you may have to pay a prorated amount of the property tax that depends on when you complete the home purchase. This will become part of your overall closing costs.
- The annual percentage rate (APR) is a number designed to help you evaluate the total cost of a loan. In addition to the interest rate, it takes into account the fees, rebates, and other costs you may encounter over the life of the loan. The APR is calculated according to federal requirements, and is required by law to be included in all mortgage loan estimates. This allows you to better compare different types of mortgages from different lenders, to see which is the right one for you.