When you’re itching to buy your first home, ready to scale up or find that it makes sense to buy rather than rent, you’ve got to come up with a budget. Home searching without an idea of what you can afford is a recipe for disappointment. Calculate what you can really afford as well as what a bank is likely to approve for you, since these two numbers may be different.
Record-low interest rates are making it easier to afford a larger loan than you might have considered before, so it’s important to factor in your past and future savings goals, your debt now and in the future, and how long you plan to live in this home. Some of these factors impact what a bank will approve, but not all of them.
Calculating: How much house can I afford?
Banks come up with the amount and interest rate for your loan based on factors that impact the risks of loaning you the money. If you are seen as less likely to pay your loan back — for instance, if you have a low or fair credit score — the bank will offer you less total value in the loan and charge higher interest to loan that money to you.
However, you’ll need to decide based on your overall financial picture, and you may want to consider making a 50/30/20 budget, where 50% is spent on needs or required expenses, 30% on wants, and 20% on savings. “This way, you know whether it will be a stretch to make that payment every month,” says R.J. Weiss, CFP® and founder of the personal finance site The Ways To Wealth.
“You’ll be able to know what the opportunity cost of that monthly payment will be. For example, does it take away from other financial goals you may have or general wants you enjoy having in your life right now, such as travel?”
Factors that determine house affordability
The bank wants to see precise information about how much money you make, be it from a regular salaried or hourly wage job or as an independent contractor or business owner. As you might expect, there is more of a burden of proof for variable income than for a W2 job, since they don’t want you to stop paying your house payment during a low month. They also want to see how long you’ve had the job, since recently-acquired jobs are seen as riskier.
Debt and expenses
Lenders look at an important ratio called the debt-to-income ratio to see whether it is wise to loan you more than a certain amount of money. Lenders prefer to see that less than 36% of your income is going to all debt payments, including the mortgage they are considering for you. If you have other debt, like student loan payments or credit card debt, this will factor into their calculations.
Your credit score reflects many factors, including how many times you’ve received credit or loans and paid them back on time, as well as how you pay monthly obligations as well. Higher credit scores make you less of a risk for the lenders, since you have a track record of making payments work whether you were in good times or tough ones. Lower credit scores don’t always disqualify you, but they do increase your interest rate.
Expenses included in a monthly mortgage payment
While some of these expenses may be separated out, usually it’s best to gauge how much you can afford based on the acronym PITIA, or principal, interest, taxes, insurance, and association dues. This is because the costs of owning a home go beyond the combination of principal and interest that you pay directly to your lender.
Because home insurance is required and most areas of the United States have some form of property tax, these are non-optional expenses that must either be saved up for a yearly payment or paid monthly into escrow.
||Amount of your monthly payment that becomes equity and directly pays back the amount you requested on the loan originally.
||Interest that your bank charges for lending you money. Earlier in the loan, a larger percentage of your payment is interest, since you have paid less of the total amount, but the % of interest relative to principal goes down over time, even as the overall monthly payment number stays the same.
||Calculate taxes based on the property taxes charged in your local municipality. You can save 1/12 what you are charged each year with each monthly payment in escrow, or just plan to pay a lump sum once or twice a year, depending on how your area charges taxes.
||Homeowners’ insurance costs vary based on the policy you choose, but some form is usually required by the lender if you are taking out a mortgage loan.
||For homes in Homeowners’ Associations (HOAs), this mandatory cost of association dues should be factored in, since you can’t avoid paying it if you buy a home in that area.
House affordability and the 28/36% rule
A common way to calculate how much house you can afford is to use the 28/36% rule looking at both your overall debt and the overall payment for your home. “This rule states your total housing expenses should be less than 28% of your gross monthly income. Also, your total debt payments should be less than 36% of your gross monthly income,” says Weiss.
However, Weiss says this should only be a starting point: “As a homeowner, you need to put your goals first, as well as analyze your own situation,” he says.
|Gross monthly income
||monthly housing expenses
||Monthly debt payments
||Mortgage payment you can afford based on $500 of monthly debt payments
||Estimated cost of house you can afford, given the $500 of debt payments.
*Note that the larger numbers create a home budget above 28% because $500 in payments is such a low percentage of these incomes. These individuals might calculate the mortgage payment they can afford based on their “monthly housing expenses” number instead of their 36%-minus-other-debts number.
**These examples are based on a conventional loan with a 20% down payment and a good credit score.
How does your down payment affect a mortgage?
The larger a down payment you can make on your home, the lower your interest rate and other costs will be, and the more house you can afford. “To secure the best long-term interest rate, you’ll want to make a 20% down payment on the house,” says Weiss. “So, the question on whether it would make sense to increase the amount of home you can buy based on today’s low rates comes down to being able to afford the 20% down payment.”
Many loan types require at least 3-5% as a down payment, and anything above that you can pay will mean you can request a smaller total loan and receive a more competitive rate.
Weiss also points out, “I find the most important question to ask is what would you do if the value of your home goes down. For some people, especially those who plan on living in their home for more than ten years, this might not even be an issue. For others, a decline in price could cause serious financial problems.