How Much Mortgage Can You Afford?

Woman using tablet to research a mortgage

Imagine you have just completed a search that included hundreds of hours of home searches. You have sized up siding, reviewed roofing, and navigated the neighborhood. And finally, you have found the house of your dreams. Now imagine that this house of your dreams costs much more than you can afford.

If you are house hunting and have not done an important piece of homework, you could be in for this kind of heartbreak. The first thing you need to know when shopping for a home is how much mortgage you can afford.

A good rule of thumb is to spend 28 percent of gross income on housing. But everyone’s financial situation varies.

The purpose of this page is to give you a more specific idea of your ideal home purchase price. It will address what you are worth and what you owe on a regular basis (your assets and liabilities) and what costs you would most likely encounter once you bought your new house.

In general, you will be examining the same things a lender looks at when deciding how large a mortgage you can afford.

What are your assets?

Before deciding how much mortgage you can afford, know how much you are worth. Take into account your income, savings, investments, and other holdings such as Individual Retirement Accounts (IRAs) or Keogh plans, the cash value of your life insurance, pensions or corporate savings plans, and equity in real estate. Lenders will need this information before deciding to extend you the loan.

Often, the amount you earn may not be as important as how you earn it. Bonuses and commissions can vary greatly from year to year. And, lenders are reluctant to depend on them if they make up a large part of your income. There are similar problems when a large portion of your salary is based on overtime pay, and you rely on it to qualify for the loan. To get a realistic view of what your income level actually is, average your income (including bonuses, commissions, and overtime) for the past two or three years.

As a last resort, pensions and corporate thrift plans can provide another source of down payment money. Most plans or policies give you the option of either withdrawing your money with no repayment or borrowing against the cash value. Though it is not the best policy for most homebuyers to borrow from these sources in addition to borrowing mortgage money, they can often get rates substantially lower than those on many other kinds of loans. Remember - if you borrow against the cash value of your life insurance or employee thrift plan, you will be making principal and interest payments for these separate from your mortgage.

While turning your savings, investments, and other holdings into cash (making them "liquid"), remember that you will probably have to pay tax on most of it. One source of tax-free money often overlooked is a gift or money given by a parent or other relative that need not be repaid. A person may give another person up to $10,000 per year without either party being taxed. Your parents, for example, could give you and your spouse up to $40,000 tax-free. Just be sure if you choose this route that you document where the funds come from. Try to have that money deposited at least 60 days before you begin the mortgage approval process.

Liabilities and debts

Your liabilities are the expenses you’re responsible for each month. These include outstanding loans, such as student, auto, personal, and so on, as well as credit card balances. When calculating your liabilities, use your full credit card balance, as if you had to pay them off entirely this month. That way, you give yourself some breathing room should you run up an unusually high balance during your mortgage term.

Emergency funds

It is always wise to put a little money away "for a rainy day" - especially when you are paying off a mortgage. If something arises such as unexpected medical costs or substantial auto repairs, you would want to be able to pay those expenses without jeopardizing your ability to meet your mortgage payments. Most financial experts suggest that you always have six months income on hand in case of emergency.

Annual income

When calculating your annual income, remember to take into account all sources. Don’t forget to include: dividends from investments, alimony, or child support payments.

Available down payment dollars

Down payments are required in order to be approved for a mortgage. Some loan programs may allow you to pay as little as 3.5 percent of the purchase price, some (specific to Colorado) may allow you to pay a flat amount as low as $1,000 down. Yet, there are other loan programs that may expect anywhere from 5-20 percent. Don’t rule out homeownership just because of the required down payment. It’s important to know there are many government assistance programs available to help get you into a home, working with you on what you can afford. Check out our Guide to Down Payment Assistance to learn more about what programs you may qualify for.

Insurance and taxes

The more you’re able to put down, the less likely you are to have to pay mortgage insurance. This may be private mortgage insurance (PMI) or a mortgage insurance premium (MIP). PMI tends to correlate with conventional loans, whereas MIP is with FHA loans.

Then there’s homeowners insurance, which can run anywhere from $500 to $1,500 per year — the national average for 2017 being $1,083.

Property taxes and maintenance costs will vary, of course, depending on the size, age, and condition of your new house. Estimates for the costs of utilities, maintenance, and improvements can be obtained from realtors, local utility companies, and others. All of these costs need consideration before making a final decision on a home purchase.

Some home buyers will have added costs if they are buying a condominium (condo) or a co-op. Condo and co-op fees, even homeowners association fees, are paid monthly on top of the mortgage payments. The fees vary greatly from location to location, so be sure to include this as you’re doing your cost analysis.

Finally, start thinking about whether or not you've found the right home. Either way, it’s always a great idea to start the mortgage pre-approval process in advance.  In this situation, getting mortgage pre-approval can help in one of two ways -- one: you can have a clear idea of how much home you can afford, and two: you can get a pre-approval letter in hand, which makes your offer on a home much stronger than others.