If you’re like many people, buying a home may be the largest purchase you make in your life. Decisions related to your home purchase can significantly impact your future financial security, shaping factors such as cash flow, savings rate and your overall financial flexibility.

Two key questions sit at the center of your home buying decision: “What is a mortgage rate?” and, “How Much House Can I Afford?” Understanding the answers to these questions can help you make informed decisions that align with your overall financial values and long-term priorities.

What is a Mortgage Rate?

A mortgage rate refers to the rate of interest a lender charges when you borrow money to purchase a home. It is expressed as an annual percentage of the loan amount, and it determines how much interest you will pay over the life of the loan.

It’s important to be aware of the difference between the interest rate and the annual percentage rate (APR).

• The interest rate is the pure cost of borrowing.

• The APR includes the interest rate plus most upfront fees and costs, which gives you a more complete picture of the loan’s true cost.

There are two main ways most borrowers structure mortgage rates.

1. Fixed-rate mortgages maintain the same interest rate for the entire term of the loan. This makes budgeting easy because your principal and interest payments remain predictable. However, you may end up paying a premium for this certainty because fixed rates are often higher than initial adjustable rates.

2. Adjustable-rate mortgages (ARMs) typically begin with a lower introductory rate for a set period of time, often between five to 10 years. After that period, the rate periodically readjusts based on a market index plus a margin. The lower starting rate can help increase your purchasing power, but you run the risk that future payments will raise if rates increase. ARMs often make the most sense for homebuyers who plan to sell or refinance before the adjustment period begins.

Mortgage rates are not the same for everyone. They fluctuate with broader economic conditions, such as Federal Reserve policy, inflation expectations and other Treasury yields. They are also impacted by your personal financial characteristics, including the following.

• Credit score – A higher credit score can result in a more favorable mortgage rate.

• Down payment – The amount you put down determines your loan-to-value ratio. A higher down payment may improve your mortgage rate.

• Loan term – 15-year loans typically have lower rates than 30-year loans.

• Debt-to-income ratio – Lenders favor borrowers who have low debt in other areas.

• Loan type – Different types of loans have different rates.

Even a small rate difference can have a big financial impact over time. For example, on a $500,000 loan, a 0.5% higher rate can cost tens of thousands of dollars more over 30 years.

How Much House Can I Afford?

There are two ways to look at this question. Many people view this as, “What is the biggest loan a bank will approve?” However, that’s generally not the best approach. A more financially healthy perspective is, “What monthly payment will help me maintain a healthy overall financial life?”

Most lenders are pleased to approve high mortgage amounts (especially for strong borrowers), as they are paid more interest on bigger loans. However, this does not mean you should stretch to the maximum. A payment that seems manageable on paper can quickly stress your budget when you factor in other home expenses, such as maintenance, furniture, utilities, appliances, upgrades, etc. Keep in mind that you must continue paying for other non-home expenses while also saving for future goals, such as retirement.

The following process can help you determine how much house you can reasonably afford.

1. Calculate your true gross monthly income, including only reliable recurring sources.

2. List all existing monthly debt payments.

3. Decide on a comfortable monthly housing payment target. A general rule of thumb is that your housing costs – including principal, interest, property tax and insurance – should not exceed 28% of your gross monthly income.

4. Subtract your estimated property taxes, homeowner’s insurance and any HOA fees from your target payment to isolate the principal-and-interest portion.

5. Use the number from Step 4, along with your expected down payment and mortgage rate, to back into a maximum purchase price.

6. Stress-test the payment under different circumstances. For example, consider whether you would be able to continue paying your mortgage if you were out of work for several months or needed to make significant repairs a few years after purchasing the home.

7. Confirm that you will still have adequate emergency savings and be able to continue contributing to your retirement savings accounts after closing on your home.

The Bottom Line

A mortgage rate is simply the cost of borrowed money, which can be impacted by both the market and your personal financial situation. How much house you can afford is a more personal question that must balance your current finances with your future goals.

As you consider your options, remember that the right home should enhance your lifestyle, not constrain it. Taking time to understand mortgage rates and how much home you can afford allows you to align your home purchase with your broader financial plan in order to remain on track toward your other financial goals.

If you could use some help determining how your home purchase may impact your financial future, we would love to have a conversation. Please schedule a call with a member of our team.