Many factors can affect how affordable it is for you to buy a home. Learn what they are so you can come up with a solid number for how much home you can afford.
How Do I Decide How Much House I Can Afford?
Figuring out how much home you can afford isn’t a straightforward answer. You’ll need to look at hard numbers and might need to adjust your home desires for what you can afford. Lenders will set an absolute cap on how much you might be approved for, but these are often much higher than financial experts recommend. Most advisors recommend a more cautious approach with two basic rules of thumb to guide you. Somewhere between those two rules will be what is right for your situation. You can do this by taking an in-depth, honest review of your finances. Consider your emotions, too: Are you comfortable buying closer to the max of your budget when that might put you more at risk of default if something were to happen down the road? Or do you prefer to play it safer and stick to the more conservative guidelines? Only you can answer these questions.
How To Estimate a Budget for Your Mortgage
First, calculate the maximum monthly payment you can afford since this will set the upper boundary for how much home you can buy. For example, the median household income between 2019 and 2020 was $67,521. With no debt, that translates into a monthly mortgage payment of $1,575 using the 28/36 rule. Next, figure out the more conservative estimates based on the 25% rule. Continuing our example, that would translate into a housing payment of $1,407 per month. But if you’ll be required to pay $100 to an HOA and want to save $200 a month for home repairs, that translates into being able to afford a payment of $1,107 per month. These two numbers—$1,407 and $1,575, in our examples—give you lower and upper bounds on what you might be able to afford. You can then use a mortgage calculator to generate an upper and lower total mortgage amount. This will give you a target price range for a home that you can be confident you can afford.
Debt-to-Income Ratio: The 28/36 Rule
Lenders use your debt-to-income ratio (DTI) to set a cap on the maximum price of a home you can buy. They use your DTI to figure out the maximum monthly mortgage payment you can afford and then back-calculate to see how large of a mortgage that works out to. Your DTI is calculated by dividing your total monthly income by your total monthly debt payments. For example, if you earn $2,000 per month before taxes and pay $200 toward your student loans, your DTI ratio is 10% (2,000 / 200 = 10). There are many different types of mortgage programs; each one has its own rules about the maximum DTI you can have and still be approved. In general, many lenders use the 28/36 rule, which limits you to:
No more than 28% of your income toward the mortgage paymentNo more than 36% of your income toward all debt payments combined, including your mortgage
If you’re paying 10% of your income toward debt, you’d be able to afford a maximum monthly mortgage payment of 26% of your income (36% - 10%). However, if you had no debt at all, you could afford a mortgage payment of up to 28% of your income.
Your Credit Score
Lenders use your DTI to determine the price of the house you can afford. One of the variables that go into that calculation is your interest rate, and your credit score has a significant impact on this. A higher credit score translates into a lower interest rate. This means you’re not paying as much to your lender, and in turn, you can be approved for a more expensive home. Conversely, a lower credit score translates into a higher interest rate, which can mean a more expensive loan and a smaller approval amount.
Down Payment
Your down payment also affects how much home you can buy. Most lenders offer conventional loans with private mortgage insurance (PMI) for down payments ranging from 5%-15%. However, you may be eligible for an FHA loan with a minimum down payment requirement of 3.5%. Down payments do much more than create eligibility for specific loans—they reduce the amount of money you pay for the loan. The more you can put down, the better off you’ll be in the long run. For example, if you have good to excellent credit, a 30-year $200,000 mortgage with a 2.35% interest rate and no down payment, you’ll pay $78,903 in interest, plus you’ll need private mortgage insurance. The same loan with a 20% down payment of $40,000 will reduce the total interest you pay to $63,123. With the same down payment and loan amount, you could change it to a 20-year mortgage and only pay $40,688 in interest.
Other Costs To Consider
The ongoing costs of buying a home are more than just your mortgage payments. You’ll also have to budget for:
HOA fees Property taxes Home upgrades Homeowners insurance Maintenance and repairs
Most financial experts recommend keeping all of these monthly expenses (mortgage included) within 25% of your income. Note that this is much lower than the amount many lenders might approve.
