For most people, home affordability ultimately depends on the answer to the question: how much is a bank or mortgage company willing to lend to me?
The amount a bank or mortgage company is willing to lend to you depends on two primary factors:
- How much money you personally contribute to buy your home (i.e. your “down payment”)
- How much money you make relative to your debts
How much money you contribute to buy your home
The reason lenders care about how much money you “put down” is because it lowers the amount of money they need to lend you to purchase your home. Furthermore, the more money you put down, the less likely you are to stop making your payments since you have more “equity” into the transaction.
Hypothetically speaking, in a scenario where your financial circumstances deteriorate, if you only put 10% down, you are more likely to stop making payments than somebody who put 30% down, because you have less money to lose. This is why lenders provide better terms to borrowers who make larger down payments.
Lenders quantify the amount you are willing to put down using a ratio called the Loan-to-Value Ratio (LTV), which is calculated as follows:
Loan-to-Value Ratio = Loan amount / Appraised value of the property
In order for you to get the best terms on your loan, lenders will require that you put at least 20% of your own money into the transaction, resulting in an 80% LTV. There are programs where you are able to put as little as 3% down, but to qualify for these programs, you will be required to make additional monthly payments to pay for an insurance policy that will protect the lender.
How much money you make relative to your debts
Lenders care about how much money you make relative to your debts because they need to be sure you have the capacity to make your mortgage payment every single month. Lenders measure this with the Debt-to-Income ratio (DTI), which is calculated as follows:
The Debt-to-Income ratio = Total monthly debt obligations/Gross monthly income
Your total monthly debt obligations will include your mortgage payment along with the taxes and insurance payments associated with the property you are buying. Lenders get an accurate account of your other monthly debt obligations by requesting a credit report from the credit bureaus, which list all your monthly debt obligations.
A DTI at or below 43% is typically accepted by all lenders. Calculating this ratio can become more complex if you derive income from multiple sources (e.g. rental properties) or your income can vary (e.g. commission and/or bonus income). If your DTI is more than 43%, you will likely need to lower your monthly debt obligations to lower the ratio to below 43%.
Getting approved for a home loan involves many more factors than the aforementioned ratios. Though, before you can even begin the process of thinking about buying a home, you need to know how much you can afford. Understanding these two ratios is a critical first step to figuring this out.