How Much Home Can You Afford?

An often-quoted rule says you can afford a house that costs up to two and one-half times your annual gross income (that is, the amount you make before taxes are deducted). If you are buying a house with someone else (spouse, parent, adult child, partner/companion, brother or sister, etc.) you can consider your co-purchaser's annual gross income in deciding how expensive a home you can buy. (Your co-purchaser's debts and credit history also will determine how much you can borrow. The co-purchaser also is liable for repayment of the mortgage.) According to this guideline, if you and your co-purchaser together have an annual income totaling $80,000, you should expect to buy a home priced at no more than $200,000; if you have a joint income of $40,000, your new home should cost no more than $100,000.

This provides a ballpark figure of what you can pay for a home. If you have access to the Internet, Web-based mortgage calculators can give you a more complete picture.

Your buying power ultimately depends on three things:
  • How much you have available for the down payment;
  • How much a financial institution will agree to lend you; and
  • Your credit situation.
Let's look first at what resources you may be able to tap for your down payment and closing costs. Then we will look at the guidelines lenders use to determine how much they will loan a homebuyer. Finally, we'll discuss credit.

a. Your Down Payment

If you are a first-time homebuyer, the price you can afford to pay for a house may be limited by the required down payment and closing costs. Unlike homeowners who can rely on their equity in a property they already own, your savings are probably your principal resource. If you haven't accumulated much savings, you may need to set aside funds for a down payment on a regular basis from your paycheck.

b. Your Borrowing Power

Apart from your down payment, the other major factor limiting how expensive a home you can buy will be how much you can borrow. When you apply for a mortgage, the lender will primarily consider three factors in determining how large a loan to grant you:
  • Earnings;
  • Existing debt level; and
  • Credit (payment) history.
Lenders' qualifying guidelines

Lenders typically use two qualifying guidelines to determine the size mortgage for which you are eligible.
    Your monthly costs (including mortgage payments, property taxes, insurance, and condominium or cooperative fee, if applicable) should total no more than 28 percent of your monthly gross (before-tax) income.

    Your monthly housing costs plus other long-term debts should total no more than 36 percent of your monthly gross income.
Lenders and financial advisors recommend that you spend no more than 25-28 percent of your income on housing and not more than 33-36 percent on total debt (housing, credit cards, and other debts). In certain situations, you can exceed these amounts, but they are a good start for a first-time homebuyer. Some local, state, and federal programs have limits on the percentage of debt someone can have in order to participate. Please talk to your NFCC HUD-approved local housing counseling agency for more information.

There are many excellent online resources to help you determine the right-sized mortgage for you. The following are several examples:

Fannie Mae: www.mortgagecontent.net/scApplication/fanniemae/affordability.do

Freddie Mac: www.freddiemac.com/corporate/buyown/english/calcs_tools

Bank Rate: www.bankrate.com/brm/mortgage-calculator.asp

When you apply for a mortgage, the lender will use all the relevant data-your income, your existing debts, the purchase price of the house, your down payment, the interest rate on the loan, and the cost of property taxes and insurance-and quickly calculate whether you qualify for the amount you need to buy the house.

Note that qualifying for a loan is only the first step in being approved. The qualification process determines how large a mortgage you are eligible for if your loan application is approved.

Pre-qualifying yourself

A smart move for first-time homebuyers is to get "prequalified" by your lender. This determines the price range in which you should shop and if there are credit issues to address prior to a home purchase. Your gross income. In calculating your gross (before-tax) income, you can count all income that you get on a regular basis, from whatever source.

Your debt payments. Lenders also will consider your existing debt in determining how large a mortgage to grant you. They are interested in your "long-term debt," any debt that will take more than 10 months to pay off.

If your monthly debt payments are excessive for your income level (based on the qualifying guidelines), this will reduce the amount you can borrow to buy a house. For every $50 of "excess debt," you can expect about a $5,000 reduction in the amount of mortgage you qualify for. If your debts are excessive, consider paying off some of your debt in preparation for buying a house. You will qualify for a larger mortgage, which may mean you can afford more house with your income.

Your Credit Record

As part of the "prequalification" process or as you begin the homebuying adventure, obtain a copy of your credit report. Knowing what's on your credit report can help the loan application process go smoothly. The lender also will pull a credit report as part of the application process, but it's wise to get your own copy each year.

You can obtain a free copy of your credit report from www.annualcreditreport.com, or for a small fee, you can request your credit profile from a credit reporting agency (look in the Yellow Pages or see our Internet resources section at the end of this chapter.). NFCC recommends that you obtain what's known as a "tri-merge" credit score, which is a combination of all three credit reporting bureaus.

Credit scoring

Credit scoring is a statistical method used to predict the likelihood that a potential borrower will repay a credit obligation, such as a mortgage loan.

A credit score is based ONLY on information in a credit report:
  • Previous credit performance;
  • Current level of indebtedness;
  • Amount of time credit has been in use;
  • Pursuit of new credit; and
  • Types of credit available.
A credit score is NOT based on factors prohibited under the Equal Credit Opportunity Act (ECOA), such as race, gender, color, religion, national origin, and marital status. Excluded from the credit score formula are income, employment, and residence.

The FICO score, developed by the Fair Isaac Corporation, is the most common credit score used in mortgage lending. The broad categories of credit data that are included in a FICO credit score are:
    Payment history (approximately 35 percent of your FICO score). Have you been late paying bills? If so, how recently did these late payments occur? How long did you remain delinquent on any bill at one time? What is the highest level of delinquency reached in the last year? How many months have passed since the most recent negative item on record (a judgment, lien, bankruptcy, etc.)? (Generally, the "worse" your credit performance is, the "worse" your credit score. Recent bad credit has a more negative impact.)

    Amounts owed (approximately 30 percent of your FICO score). How many consumer loans and open charge accounts do you have? What is the ratio of revolving debt to total revolving limits available to you? What is the percentage outstanding on open installment loans? (Generally, the higher the percentage of utilization of credit, the higher the risk. So DO NOT max out your credit cards!)

    Length of credit history (approximately 15 percent of your FICO score). How long have you had credit? (Generally, the longer you have had credit and have successfully managed your debts, the better the credit score. However, even if you have a relatively new credit history or only one or two traditional accounts, you can obtain high scores as well.)

    New credit (approximately 10 percent of your FICO score). Are you pursuing new sources of credit, such as an automobile loan? To measure such activity accurately, the credit score calculation only takes inquiries you initiated into account.
The score takes into account inquiries over a 12-month period. Any inquiries related to automobiles and mortgages that occurred over the past 30 days are excluded. And if multiple automobile or mortgage-related inquiries occur in any 14-day period, they are considered a single inquiry.

The credit score model does not include inquiries you did not initiate. For example, banks mail promotions to consumers to whom they would LIKE to issue a credit card. Such inquiries appear on your report as PRM or promotional inquiries and do not influence your credit score.
    Types of credit in use (approximately 10 percent of your FICO score). What types of credit do you have? Department store credit cards? Bank-issued credit cards? Installment credit with a local furniture store? (Generally, the types of credit available are not as important a factor in determining a credit score as the other categories.)

    Establishing a credit record

    If you have no credit record either good or bad, now is the time to establish one. If you do not have a traditional credit record that shows payments made on credit card purchases, a car loan, or student loan, it is still possible to establish a credit history. For example, you can build a nontraditional credit history by documenting your monthly rent payments to previous landlords; utility companies for electricity, gas, water, and telephone services; cable television companies; or insurance companies for medical, automobile, and life insurance.

    Repairing a bad credit record

    You also may find that your credit record is not as clean as you might wish. If you are currently having credit problems, you may not be able to buy a house until they are resolved. If your problems are in the past, your recent track record of timely debt payment may help. By law, most unfavorable credit information must be dropped from your credit file after seven years. A bankruptcy remains on your credit report for 10 years.

    If you are behind on your bills and feel overwhelmed by debt, consider credit counseling. NFCC member agencies have nearly 1,000 offices around the country and can help develop a plan for improving your credit profile. To contact an NFCC counselor, call (866) 687-6322 or visit our Web site at www.nfcc.org.

    Dealing with incorrect information on your credit record

    Unfortunately, credit reports sometimes are inaccurate or give a misleading picture of past credit problems that have since been resolved.

    To avoid any unpleasant surprises, you should obtain a copy of your credit report right now. You don't want to take the chance of being denied a mortgage because of an erroneous credit report. If you find errors, you should correct your report before applying for a mortgage. If you have an unresolved dispute with a creditor, the credit agency must include your explanation of the situation in future credit reports. Make it a habit to check your credit report every year, moving forward.

©2007 National Foundation for Credit Counseling