A Homebuyer’s Guide to Calculating a Mortgage

Buying a new home is a rewarding milestone, but it doesn’t come cheap. After careful budgeting and penny pinching to save for what’s likely the biggest purchase you’ll make in your lifetime, you may be wondering just how much mortgage you can afford.

Figuring out how much house you can afford is a key step in the home-buying process. A lot of number crunching goes into it — from you and from your lender. As a rule, lenders typically suggest that prospective homebuyers can finance a loan that’s about 2 to 2.5 times their gross income. If you’re a couple earning about $200,000 together, that means you can afford a mortgage of at least $400,000, for example. But this doesn’t take into consideration other factors like your individual financial and personal circumstances.

Let’s look at some factors to help you determine how much mortgage you can realistically take on.

Tally Your Income, Debts and Potential Monthly Payment

Start by running your own numbers, so you can decide, independently, how much mortgage you can comfortably afford without becoming house poor. House poor is when the majority of your income is being funneled into the cost of your home, leaving you with little income left for other categories of your household budget.

Add up your monthly income from all revenue streams — your job, rental earnings, investments — this is how much you have to work with for your budget. Next, tally your debt repayments, such as credit cards, student loans and lines of credit, and how much you’ll need to commit to paying these off each month. 

Consider all of your non-housing monthly expenses too. This includes looking at your childcare expenses, car payments and fixed expenses including utilities and subscriptions. 

What’s leftover? This amount can go toward your mortgage payment, homeowner’s insurance, property taxes and other expenses that come along with homeownership. But you need to tread carefully here. While you may have a large sum leftover, you shouldn’t max out your income on your mortgage; there needs to be wiggle room to save for unforeseen expenses. You may also have other ongoing priorities such as saving for retirement.

Writing down all of your income and expenses is a great exercise as it preps you for precisely what lenders will evaluate when they determine how much they’ll qualify you for in a loan. 

This step also factors in your individual lifestyle needs. While lenders and online calculators use a formulaic approach in deciding how much you can afford, only you are attuned to how much you spend on entertainment or eating out, and how much you’re genuinely willing to cut back on in discretionary spending to make your dream home come true.

Consider the 30 Percent Rule

On top of the 2 to 2.5 times your gross income tactic, personal finance experts suggest allocating 25 percent to 30 percent of your gross monthly income toward housing expenses. Twenty-eight percent is typically the magic number here.

Lenders call your mortgage payments “PITI” or principal, interest, taxes and insurance (property insurance and private mortgage insurance, if needed). Your PITI shouldn’t be more than that 28 percent.

Overall, you shouldn’t be spending more than 36 percent in total for all debts. That encompasses everything from your mortgage to your consumer debt to your car payments. Once your monthly expenses exceed this ratio, you head into murky waters as you risk not having enough money to cover your cost of living.

How Lenders Calculate Your Mortgage Loan

There are no sweeping approaches to how lenders determine how much mortgage consumers can afford, but they look at nearly identical criteria across the board. Gaining insight into what your lender thinks you can take on and how they decide this can help you build your case.

Here’s what they prioritize and what you need to keep in mind to be a star candidate for a loan. 

Your down payment. This is the lump sum payment you make when you purchase your home. Most lenders require that homebuyers put down 20 percent of their home’s purchase price to qualify for a conventional loan. 

It’s a hefty commitment, so if you don’t have enough saved up or don’t want to put all of your savings into your down payment, don’t panic. There are loan options that may accommodate smaller down payments. You can also take out private mortgage insurance (PMI), or you may be required to depending on your lender and loan, if you can’t put the full 20 percent down. 

How much you commit to in your down payment helps your lender determine what size loan you will need to afford the rest of your house. The bigger the down payment, the smaller the loan — and the less risk to lenders. 

Your credit score and creditworthiness. Similar to when you apply for a credit card or a line of credit, your lender is running a background check on you so your best bet is to get your financial ducks in a row. They’ll consider your gross income, how stable your income is, any Social Security benefits and, most critically, your credit score. Your credit history is incredibly telling — have you defaulted on loans before and are you punctual with payments? 

Applicants with a low credit score could end up paying higher interest rates on their loans because they aren’t seen as trustworthy to lenders. Before you apply for a loan, pull your credit reports from Equifax, TransUnion and Experian to make sure there aren’t any surprises and you can address any issues.

Lenders reward those with the highest credit scores, minimal debt and sizeable down payments with the lowest interest rates. Thus, it’s worth your while to get yourself in the best financial health possible.

Your debt-to-income ratio. Just as we advised calculating all of your debts as part of your financial picture, lenders are doing the same to determine your debt-to-income ratio or how much of your income is being dedicated to your debts.

Lenders tally all of your liabilities, including your credit card payments, auto loans, student loans, lines of credit and child support and consider how much you need to commit to each of these debts.

If servicing your debt takes up more than 36 percent of your gross income, your lender may be wary that your income is insufficient to cover all of your debts. This is why it’s important to tackle your debts as much as you can before you approach lenders about buying a home.

It’s worth noting that debt-to-income ratio doesn’t include your regular monthly expenses like your bills and subscriptions.

The terms of your loan. If you’re committing to homeownership, you’re about to get closely acquainted with mortgage speak, from interest rates to amortization periods.

The terms of your loan (fixed or variable interest rate, loan type, length of loan) are factored into the equation lenders use, too: For example, if you are making a sizeable down payment on a $400,000 home, you’ll likely secure more favorable loan terms compared to someone putting 5 percent down on a $700,000 home.

Ultimately, your lender needs to know that you can handle your loan and its terms based on your income, assets and liabilities.

The Role of Online Mortgage Calculators

Online mortgage calculators are readily available to help you do the clunky math in determining how much you can conventionally afford. They’re a great jumping-off point as you gain an understanding of what’s factored into home affordability equations. In the most bare-bones options, you simply plug in your income, your down payment, your monthly debts, and your loan length and the calculator will spit out a number of how much mortgage you can afford. Others are more detailed asking for your monthly utilities, dependents, entertainment budget, housing expenses, travel and miscellaneous spending.

Take each of these calculators with a grain of salt, though. Because they’re being applied to the wider population, they don’t take into account your individual circumstances, such as how stable your income is, if you’re planning on expanding your family or if you’re aging and needing to move into part-time work or facing medical expenses and higher health insurance premiums.

Personal finance experts also note that these calculators look at your gross income and don’t consider paycheck deductions for taxes, employee benefits and other programs. 

These calculators — and what your lender ultimately qualifies you for — don’t account for your personal comfort with debt either. Some people sleep easier at night knowing their mortgage will be manageable and malleable should they face a job loss, leaky roof or other unforeseen expenses. Others make the mistake of qualifying for a generous loan and start shopping for a house on the upper end of what they’ve just qualified for. Remember, just because you qualify for a certain amount, that doesn’t necessarily mean you can afford it.

Don’t forget about the other expenses that come with homeownership, especially if you’re a first-timer. You’ll need to buy new furniture, home décor and potentially expensive appliances, such as a refrigerator or dishwasher. You’ll also incur closing costs on your home purchase, which can be up to 5 percent, or more, of the loan amount.

And just as renters do, you need to factor in an emergency savings net to cover about three to six months’ worth of expenses.

The Bottom Line

Do your homework with your own number crunching and play around with various online calculators to get a feel for what you may be able to take on in a mortgage. 

Shop around with various lenders to see what they offer, what products they have and what rates you can secure. You can even prequalify for a loan, which isn’t set in stone or guaranteed, but provides you with an idea of the types of loans lenders could offer you and how much mortgage they think you can afford.