How do I know 'how much' house I can afford?
There are several ways to gauge how much you can afford to spend on a house. But, before you go house-hunting, get pre-qualified for a mortgage so you'll know in what price range you can shop.
It is not unusual for first-time buyers to be somewhat baffled about how to estimate what mortgage payment they will be able to handle each month, plus how much money they'll need for a down payment and closing costs.
That's why it is a good idea to get pre-qualified through a lender before you even start to look for a home. Pre-qualification lets a buyer know exactly how much a lender is willing to loan them. Obviously, with pre-qualification in hand, the buyer can save a lot of time and frustration. Pre-qualification does not obligate buyers to take a loan from the lender, nor should it involve any fees (until later, when they actually apply for the loan).
At the same time, you must understand that pre-qualification is not pre-approval for a loan either which is a much more involved formalized process that results in an actual letter of credit from a lending institution for a specific loan. Depending on your unique circumstances, you may wish to consider pre-approval as an option, but it is not necessary. Consult with your real estate professional to decide what's right for you.
The less formal process of pre-qualifying on the other hand is a tremendous tool for buyers to have when making an offer. Usually, pre-qualified buyers have an edge when making a purchase offer because the seller knows that the buyer is pre-qualified, and that there is at least one lender ready to make it happen.
In addition, it allows you the flexibility to choose the mortgage that is best for you at the time of actual purchase - which is sometimes months down the road. That can be important given the volatility of interest rates.
When a lender pre-qualifies, they are more concerned about the buyer's paying ability than the price of the property. For this reason, lenders are interested in more than just a buyer's income. They also want to know how much existing debt a buyer has, what their on-going financial obligations happen to be, and what the buyer's monthly budget looks like.
Lenders use an established debt-to-income ratio, usually between .28 to 1 and .38 to 1, to calculate the amount of the loan they are willing to give to a buyer. For instance, a lender who uses a .3 to 1 debt-to-income ratio has determined that payments toward debt reduction, including existing debt plus new debt associated with buying a home, cannot be more than 30% of they buyer's gross monthly income.
An important factor that may influence a lender to authorize a loan with a higher debt-to-income ratio (where debt payments take a higher percentage of a buyer's income) is a larger down payment. Buyers who put a larger percentage of the purchase price down (5%, 10%, 15%, 20%, etc.) are considered better "risks," because the theory is that the more a person has actually invested in the purchase, the less likely they are to default on the loan.
Buyers usually discover that the pre-qualification process will produce a home purchase price that is roughly 2 1/2 to 3 times their gross annual income. The 2 1/2 -to-3 guideline is only a general rule of thumb, however, and it doesn't take a buyer's full financial situation into consideration. Since the lender's calculations will also consider a buyer's actual debts and ongoing expenses, the loan pre-qualification amount may be higher or lower.
Regardless of the price bracket a buyer targets, they should keep pre-qualification in mind
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