One of the most important things you can do when you begin your home search is to figure out “how much home can I afford?”. In this installment of Morty’s Whiteboard, we’re going to walk you through the home affordability analysis so that you can go home-hunting like an expert.
Keep in mind that at MortgageHippo, we’ve built a mortgage calculator to make figuring out home affordability a breeze, so don’t sweat the math.
Ok, let’s get started.
Home Affordability: Down Payment
There are two factors that determine how much home you can afford: your down payment and the maximum monthly mortgage payment you can afford, according to guidelines.
The down payment part is very simple: how much money do you have available for a down payment?
Different loan programs have different guidelines on where your down payment can come from (e.g., down payment gift from parents, etc.), but for now let’s just assume you have $15,000 in the bank ready to be used for your down payment.
Since many loan programs need a minimum of 5% down, the maximum loan amount you’ll be able to qualify for based on down payment alone is $300,000.
We’ll come back to this number at the end of our analysis to make sure we’re not looking for a property that exceeds this amount.
Home Affordability: Maximum Monthly Mortgage Payment
Down payment was cake, right? Gear up, figuring out the monthly payment affordability part isn’t quite as simple.
There are several factors to consider here: the interest rate on your loan (impacted by your credit score), the loan term, property taxes and insurance, your gross monthly income, your monthly debt obligations (credit cards, car payments, student loans, etc.), and the Debt-to-Income (DTI) Ratio (expected monthly mortgage expense plus other monthly debt obligations divided by your monthly income) permitted by the loan program.
“You lost me at ‘several factors’.”
Ok, fair enough. To simplify our example, let’s make the following assumptions:
Loan Term: 30 years
Interest Rate (based on a credit score of 720): 4.375%
Property taxes and Insurance: $330/month
DTI Ratio permitted by loan program: up to 43%
Gross Monthly Income: $5,000
Monthly Debt Obligations: $650
Let’s take a quick look at the formula to determine your monthly payment affordability:
Max. Monthly Payment = (Gross Monthly Income x DTI Ratio) – Monthly Debt Obligations
Now let’s plug in some numbers based on the assumptions above:
Max. Monthly Payment = ($5,000 x 0.43) – $650
Max. Monthly Payment = $1,500
This maximum monthly payment includes principal, interest, taxes, and insurance. But what really matters when figuring out what loan amount you can afford is to just look at principal and interest.
So let’s subtract $330 from the Max. Monthly Payment of $1,500, leaving us with a Maximum Monthly Principal & Interest of $1,170.
Based on this Max. Monthly Principal & Interest, the maximum loan amount for which you would qualify at the assumed interest rate of 4.375% on a 30-year loan is $234,334.98. Boom!
(Wait, where did you get that number from? Well, we have a serious mortgage calculator that we built for ourselves and our customers.)
If you want to keep your DTI Ratio in the safe zone of 36%, instead of 43%, the maximum loan amount for which you would qualify is $164,234.77.
Home Affordability: Property Price
Now let’s add your $15,000 down payment to these two loan amounts to determine your property price range:
Ideal Property Price = $164,235 + $15,000 = $179,235
Upper Limit Property Price = $234,335 + $15,000 = $249,335
Finally, let’s get back to our down payment limit of $300,000 to check the upper limit property price.
If your upper limit exceeded $300,000, you would be constrained by the amount you have available for a down payment. In this case, your upper limit of $250k is below your down payment limit, so we’re good!
So how much house can you afford given this analysis? Between $180k and $250K. The closer you stay to your ideal price of $180k, the better, but it’s also good to know you can stretch a little if you find your dream house.
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We agree, figuring out “how much home can I afford?” can get a little complicated. The good news is that, at MortgageHippo, we’re developing the smartest mortgage tool out there to seamlessly walk first-time home buyers through this and other mortgage decisions.
So put your calculator down and enjoy your home buying experience to the fullest!
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