Nearly 6.5 million people bought homes in 2020. One thing that almost all of them had in common: They all had a spending limit for how much they could buy.
If you're in the market to buy a home, too, you might wonder how much you can get preapproved for, especially given how fast home prices have been rising. In general, the two biggest factors that affect how much home you can buy are your income and your debt. Here's how lenders calculate how much to lend you.
- Lenders use your debt-to-income (DTI) ratio to calculate the maximum monthly payment you can afford.
- Lenders then back-calculate to figure out what mortgage size fits that monthly payment.
- Your interest rate, homeowners insurance, property taxes, and homeowners association (HOA) fees also affect how big a mortgage you can take out.
- It's generally best not to buy a house for the maximum you're approved for because this puts you in danger of being “house poor.”
How Are Preapprovals Determined?
When it comes to how much lenders are willing to let you borrow, it generally comes down to two things: your debt and your income, according to Nadia Evangelou, a senior economist and director of forecasting for the National Association of Realtors.
Lenders combine these two numbers into one metric: your debt-to-income ratio. It's just a measure of your total monthly debt payments, divided by your total monthly income. Here's how lenders use it to calculate how much you can get preapproved for:
Step 1: What Monthly Payment Can You Afford?
First, lenders will look at the maximum monthly payment you can afford. In general, lenders limit you to a 43% debt-to-income ratio, or DTI. In other words, no more than 43% of your gross income can go toward debt payments, your potential mortgage payment included.
Let's look at an example to see how this works. If your family earned $60,000 per year ($5,000 per month) and you had zero debts, the maximum monthly mortgage payment that most lenders might approve you for is $2,150 ($5,000 x 0.43).
But if you're like most families, you're already paying toward some type of debt. In this case, you'd subtract your monthly debt payments from your maximum monthly mortgage payment. For example, if you had a $500 student loan payment, you'd be left with a potential maximum monthly mortgage payment of $1,650.
Step 2: What's Your Interest Rate?
Next, your lender will figure out what sort of interest rate you can qualify for, because that's one of the most important factors affecting your monthly payment amount.
Your interest rate is determined by a few things, chiefly your credit score. If you have good credit, you'll generally qualify for the lowest interest rates, and that means a bigger potential loan. Some types of mortgages are cheaper than others, too.
In December 2021, the average 30-year U.S. Department of Veterans Affairs (VA) loan carried an interest rate of 2.99%, according to mortgage application processing software company Ellie Mae. The average 30-year Federal Housing Administration (FHA) loan, by contrast, was much more expensive, with an average interest rate of 3.39%.
Step 3: What's the Minimum Down Payment?
Another big factor affecting your monthly payment amount is how much of a down payment you make. Most experts recommend aiming for 20%, but many mortgage programs don't require you to pay that much. Instead, most mortgages only require you to put as little as 3% down (or zero down, in the case of VA loans).
In December 2021, the median home price was $377,700. If you made the minimum down payment of 3% at that price, you'd need to pay $11,331 upfront, and thus your actual loan size would be $366,369.
Step 4: What Are Your Property Tax and Insurance Costs?
Your mortgage payment doesn't just go to your lender. Some of that money will also be split up and sent to pay your property taxes and homeowners insurance for you. If you make a down payment of less than 20%, most lenders will also require you to pay an additional private mortgage insurance (PMI) premium.
These costs will vary, depending on where you live and how much your home is worth. For example, in 2018, the average homeowners insurance plan cost $1,249 per year, or $104 per month. In California, the average annual property tax payment in 2019 was 0.70% of the home's value. For a home worth $377,700, that translates into a property tax payment of $2,644 per year, or $220 per month.
These expenses eat away at how much home you can afford. For example, if you can afford a mortgage payment of $1,650, you might only be sending $1,326 toward your actual mortgage each month after paying $104 for insurance and $220 for property taxes.
Step 5: What's Your Maximum Preapproval Amount?
Now your lender will enter all of these numbers into a calculator to figure out the biggest loan you could be approved for, given all of these factors that go into your monthly mortgage payment.
You can do the same thing yourself with this calculator. Based on the example numbers we gave throughout these steps, here's what you would enter into the calculator:
- Monthly payment: $2,150
- Down payment: $11,331
- Interest rate: 3.39%
- Annual taxes: $2,644
- Annual insurance: $1,249
Based on the calculator output for our example, you would likely be approved for a home up to $423,495.
Even though a lender might approve you for a high mortgage amount, most experts recommend that you not buy the most expensive home your lender will allow.
This puts you more at risk of being house poor or even losing your home, especially if you find out it needs a lot of repairs or you unexpectedly lose a source of income.
What To Do When Your Preapproval Is Low
If your preapproval amount is lower than you'd like, you have a few options:
- Shop around: Different lenders may charge different interest rates, or be willing to work with you on mortgage programs that could be more favorable for you.
- Pay down debt: Your DTI (and thus how much you can afford) is determined by how much debt you have. Pay down your debt, and you'll be able to afford a larger mortgage.
- Work on your credit: If you don't qualify for the best rates, try working on your credit score so you aren't spending as much on financing costs. This will boost the amount you can afford.
- Increase your income: The other side of the DTI coin is your income. If you boost your income, you could qualify for a larger preapproval amount.
- Save up a larger down payment: Because most mortgages require a certain percentage down, a larger down payment translates into a potentially larger preapproval amount.
Frequently Asked Questions (FAQs)
How do you prequalify for a home loan if you have an existing mortgage?
If you already have a mortgage, your lender will take this into account when calculating your DTI ratio for your next home loan. Whether you plan to keep or sell that home, your lender will look to make sure you're able to pay both mortgages. Alternatively, there are several other strategies for financing your next home while you're working on selling your first.
What information and documents do you need to provide to prequalify for a mortgage?
You'll need to provide documents showing your financial history to prequalify. Most lenders require two years' worth of past tax returns and W-2 forms, as well as your two most recent bank statements and pay stubs. You'll also need documents showing any other forms of income, such as child support or Social Security income.