Man filling out a mortgage applicationAn important step during the home buying process is determining if you qualify for home ownership and how much home you can afford.  Figuring out how much mortgage you can comfortably afford is somewhat difficult because different lenders use different criteria, but you can get a fairly good idea by looking at a few different factors:

A) Credit Rating

Your credit rating estimates how likely you are to pay back a loan, and it’s usually expressed by means of a FICO score – in the US, FICO scores fall between 300-850, with 723 at the median.  Normally, you’d need a FICO score of 720 to qualify for a mortgage, but as you’ll see below, because you’re a first time home buyer you can get a mortgage with a FICO score as low as the mid-400s.  If your score is lower than 400, consult a financial expert for ways to improve it before you apply for a mortgage.

Start by finding out what your score is.  There are three major credit reporting companies: Equifax, Experian, and Trans Union. Getting your credit report is as easy as calling and asking for one.  Once you receive your report, make sure it’s accurate.  It’s also a good idea to get copies from all three companies since any one of the three could be providing a report to your lender.

Note:  Every time you apply for any kind of loan, the lender will make a “hard” enquiry to one of the rating agencies to get your credit rating, and that enquiry stays on your credit file for years.  One of the things lenders don’t want to see is a whole lot of requests for credit, because it looks to the lender as if you’ve been fishing for as much credit as you can get – a bad sign.  However, self-enquiries are considered “soft” enquiries and won’t show up when a lender looks at your score.

B) Income

A rule of thumb used to estimate the maximum price of a home you can afford is between two and two and a half times your gross annual income, depending on mortgage interest rates at the time.  For example, if you make $40,000, you’ll be able to afford a house somewhere in the neighborhood of $80,000 – $100,000 as long as rates are relatively low.

C) Housing Debt

Your actual housing debt will consist of the cost of principal and interest to repay the mortgage loan, real estate taxes, private mortgage insurance (PMI) and homeowners insurance (all together, these things are also known as PITI – Principal, Interest, Taxes and Insurance).  Mortgage insurance has already been covered above, so lets take a look at taxes next.

Taxes – After the monthly mortgage payment, your biggest fixed expense for the house will often be the property tax (also called millage tax). In some states, the property tax is collected on the local level, which means you’ll have to do some research to estimate how much house you can afford.  Your real estate tax will likely be between 1% and 3% of the mortgage on an annual basis depending on where you plan to buy. While 1% to 3% may not sound like much, it makes a difference in the house payment you can afford, and the bank may force you to include the taxes in the monthly mortgage payment.

The costs of principal interest taxes and insurance (PITI) divided by your income is called your housing expense ratio.  A general rule of thumb says that the ratio should be at about 30% of your total gross monthly household income. If you’re buying a home with your spouse, you can use both incomes to determine your housing expense ratio.

D) Debt to Income Ratio

When you’re applying for a mortgage, the bank will also take into consideration your total existing debt.  There’s a limit to the amount of gross income that it’ll allow you to apply to these other debts (known as recurring debts). A recurring debt is any payment you make on an ongoing basis and includes all loans and debt you’re currently servicing (student loans, credit card payments, alimony, etc.).  As a rule, your total monthly recurring debt plus total monthly housing debt can be no more than 40% of your total gross monthly household income for most mortgage loans.  For a closer calculation, there are many debt to income calculators online, but here’s one that works well:  Debt to Income Calculator.

E) Down payment

Traditional mortgages usually require a 20% down payment, but as a first time home owner you’ll qualify for a number of programs that can lower the amount you need to as little as zero in some cases.  The catch is that you’ll likely have to buy Private Mortgage Insurance (described below) if you have less than 20%.  That means you’ll have some extra costs loaded on to the principle of your mortgage, but it also means that you’ll be able to take advantage of fire-sale prices while they last.  Assuming home prices rise again, that makes perfect sense.

Check with the Federal Housing Administration or Veteran’s Administration as well as state housing authorities for programs to assist first-time and low to moderate income families get a mortgage with a lower down payment. The US Department of Agriculture RD also offers a program to encourage low to moderate-income buyers to purchase in rural areas.

Important note:  These rules are not set in stone and each lender is different, so don’t assume you can’t afford a home just because you don’t think you have enough money saved. FHA loans are a great option for first-time home buyers with less than 20% saved for a down payment.