I Make $120,000 a Year. How Much House Can I Afford?

The journey to homeownership begins with a question: how much house can I afford? While annual income provides a foundation, determining home-buying power involves a comprehensive look at your finances beyond salary. It requires understanding costs, lender expectations, and financial planning. This step empowers you to approach the housing market with confidence and a clear financial picture.

Understanding Your Income and Debts for Affordability

Lenders assess your financial standing to determine how much they will lend for a home purchase. Your gross salary is a primary factor. Lenders also consider other income sources like bonuses, commissions, or self-employment income, which must be demonstrated over two years for stability. Consistency and reliability are important in a lender’s evaluation.

Existing debts play an important role in affordability. Monthly obligations like credit card minimum payments, car loans, student loan payments, and other personal loans are factored in. These recurring commitments reduce income for a mortgage payment. Understanding and managing your debt load is a proactive step for a home loan application.

Lenders use the Debt-to-Income (DTI) ratio, which compares total monthly debt payments to gross monthly income. To calculate your DTI, sum all recurring monthly debt payments, including an estimated future mortgage payment, then divide by gross monthly income. For example, if your gross monthly income is $10,000 and your total monthly debt payments are $2,000, your DTI would be 20%. A lower DTI indicates a healthier financial position and greater capacity for a mortgage.

Lenders look for a DTI ratio at or below 43%, though some allow higher ratios for borrowers with strong compensating factors like a high credit score or substantial cash reserves. Reducing existing debt before applying for a mortgage can improve your DTI, increasing the amount of home you can afford or securing more favorable loan terms. This self-assessment provides a realistic preview of how lenders will view your financial capacity.

Key Costs Beyond the Purchase Price

Purchasing a home involves financial obligations beyond the sale price. The down payment is the portion of the home’s purchase price you pay directly. Its size impacts your monthly mortgage payments, interest rate, and whether you need private mortgage insurance (PMI). While some loan programs allow for down payments as low as 3% to 5%, a 20% down payment is recommended to avoid PMI and secure better loan terms. For a $450,000 home, a 20% down payment would be $90,000.

Closing costs are fees paid when the home purchase is finalized. These costs range from 2% to 5% of the loan amount and include charges such as loan origination fees, appraisal fees, title insurance, and recording fees. For example, on a $400,000 loan, closing costs could range from $8,000 to $20,000. These fees cover the administrative and legal processes involved in transferring property ownership and securing the mortgage.

Beyond the initial purchase, ongoing monthly expenses contribute to homeownership costs. Property taxes, levied by local governments, are a recurring cost that varies by location and assessed home value. Homeowner’s insurance is also a mandatory expense, protecting your investment against damage, and lenders require it. These two, along with the principal and interest, form the core of your monthly housing payment, often referred to as PITI.

If the home is part of a planned community or condominium, you might incur Homeowners Association (HOA) fees. These fees cover the maintenance of common areas, amenities, and sometimes utilities. While not all homes have HOA fees, they add to your monthly housing budget. Budget for ongoing maintenance and repairs, as homes require upkeep, with some experts suggesting setting aside 1% to 4% of the home’s value annually.

Lender Calculations for Affordability

Mortgage lenders employ guidelines to determine the maximum loan amount a borrower can afford, relying on income and debt. The 28/36 rule assesses a borrower’s capacity to manage housing costs and overall debt. This rule suggests monthly housing expenses (the front-end ratio) should not exceed 28% of your gross monthly income. Housing expenses include the principal and interest payment, property taxes, homeowner’s insurance (PITI), and any HOA fees.

The second part of the 28/36 rule, the back-end ratio, dictates total monthly debt payments, including housing costs and other debts, should not exceed 36% of your gross monthly income. This ratio includes car loans, student loans, credit card minimum payments, and other recurring debt obligations. Lenders use this ratio to ensure a borrower has enough disposable income after debt obligations are met to cover living expenses and maintain financial stability.

With an annual income of $120,000, your gross monthly income is $10,000. Applying the 28% front-end ratio, your maximum monthly housing payment (PITI + HOA) is $2,800 ($10,000 x 0.28). For the 36% back-end ratio, total monthly debt payments, including housing, should not exceed $3,600 ($10,000 x 0.36). If you have existing monthly debts of $700 (e.g., $400 car payment, $300 student loan), your maximum allowable housing payment would be $3,600 minus $700, equaling $2,900. In this scenario, the lender would use the lower calculation, $2,800 (from the 28% rule), as your maximum monthly housing expense.

These ratios are guidelines, and actual lender requirements vary based on factors like your credit score, loan program (e.g., FHA, VA, conventional), and prevailing interest rates. A higher credit score, for instance, can allow higher DTI ratios, while fluctuating interest rates directly impact the principal and interest portion of your monthly payment. Understanding these lender methodologies helps align your expectations with what financial institutions offer.

Getting Pre-Approved

Obtaining mortgage pre-approval is an important step in the home-buying process, providing a formal indication of how much a lender will lend you. This process involves a review of your financial information by a lender, such as a bank, credit union, or mortgage broker. It differs from a pre-qualification, which is an informal estimate based on self-reported information; pre-approval requires verification of your financial details.

During the pre-approval application, you will provide documents verifying your income, assets, and debts. Common documents include recent pay stubs (last 30 to 60 days) and W-2 forms or tax returns from the past two years to confirm employment and income history. For self-employed individuals, lenders require two years of business tax returns, profit-and-loss statements, and business bank statements.

You will also provide bank statements (past two to three months) for checking, savings, and investment accounts to verify funds for a down payment and closing costs. Statements for outstanding loans (e.g., car, student, credit card) are required to assess debt obligations. Lenders also obtain your credit report and score to evaluate creditworthiness.

Securing a pre-approval offers several benefits. It clarifies your budget, allowing you to focus your home search within your confirmed price range. A pre-approval letter strengthens your offer, showing sellers you are a serious and qualified buyer, which is advantageous in competitive markets. This formal letter states the maximum loan amount, an estimated interest rate, and loan terms. It remains valid for 60 to 90 days, after which it needs renewal.