How Much House Can I Afford?

A new home is one of the most exciting purchases you’ll make in your lifetime—but it’s also one of the heftiest! Before you set out on your search for the perfect property, it’s critical to know how much house you can actually afford based on your current income level (and expenses) before you find yourself overloaded with debt.

Understanding home affordability: important factors

When you’re trying to determine how much home you can afford, a variety of numbers may factor into your calculations including your monthly income, monthly expenses, and the amount of debt your lender believes you can take on.

Be sure to take stock of all of these metrics before landing on your optimal mortgage payment amount:

-       Your monthly or yearly income including all sources of revenue ranging from your primary job to any passive income streams you receive (generally, the steadier your income, the better)

-       All of your estimated monthly expenses including not only essentials such as food, transportation, cleaning supplies, etc. but also any debt payments (e.g., student loans, auto loans, and more)

-       Savings that can contribute to a minimum down payment, typically 20% of the home’s purchase price (put down anything less—even if you qualify for an FHA loan—and you’ll need to pay mortgage insurance premiums to protect the lender should you default)

-       Cash reserves that can cover closing costs and beyond (furniture, home upgrades, and other expenses you’ll incur after moving into your new home)

-       The type of mortgage you’d like to take on (e.g., fixed-rate versus adjustable-rate (ARMs) and term), knowing that ARMs generally have lower starting rates than fixed-rate loans and thus add some initial flexibility to your budget (these aren’t right for everyone, however, as rates are sometimes unpredictable over the life of the loan)

-       Your credit score, keeping in mind that while 620 is often the minimum score to receive an approval, boosting your number is the best path towards qualifying for the lowest mortgage rate possible

A combination of these factors impacts the average monthly cost of your home. Next, we’ll look at some key ratios lenders use to judge if you can handle your mortgage debt.

Following the 28/36 rule when purchasing a home

The 28/36 rule (or any similar ratio) is a useful guideline that can help you determine how much home you can afford: dictating that you spend no more than 28% of your gross household income on home-related debts including your mortgage, property taxes, homeowners’ insurance, and homeowner’s association (HOA) fees.

The second number (36) represents your monthly total debt payments, which shouldn’t exceed 36% of your monthly income. This number includes not only your monthly mortgage payments but in fact all monthly debts including credit cards, car payments, student loans, business loans, and more.

For example, if you make $100,000 per year, the 28/36 rule states that your mortgage shouldn’t exceed $28,000 per year ($2,333 per month) and you shouldn’t pay more than $36,000 a year ($3,000 a month) in total debt expenses. You should heed both numbers simultaneously, so if your mortgage is technically less than 28% of your monthly income but your total monthly debts exceed 36% of the same, you may want to consider pushing off your purchase until you pay down additional debt or find a less expensive property.

While this rule is just a guideline as most lenders will allow you to exceed each threshold (with the exact amount varying by lender), it is an excellent rule of thumb to prevent you and any co-borrowers from drowning in monthly mortgage payments.

What is a debt-to-income ratio?

Your debt-to-income ratio (DTI) is determined by dividing your total monthly debt by your gross monthly income. This figure is principally used by lenders—in addition to your credit profile—to assess whether you’re a good candidate for a loan or mortgage.

As one might expect, the lower your DTI, the better. A “good” DTI likely falls under 35%, but if you can push it lower, lenders will be more likely to lend to you. However, akin to the 28/36 rule, thresholds vary by lender.

More granularly, a DTI works like this: Let’s say you made $10,000 per month but your total monthly debt payments amounted to $5,000 per month. Your DTI would be calculated at 50% ((5,000 / 10,000) x 100 = 50%), which is far too high for most mortgage types (most lenders cap their top thresholds from 41–43%).

You can employ various strategies to lower a high DTI before seeking a loan such as paying off your credit cards, increasing your debt payments, and unearthing ways to boost your monthly income.

My ratios seem fine; what should I do next?

Before you apply for a mortgage, learn the difference between mortgage interest rates and APRs as various fees (often due at closing) can eat up a chunk of your savings. Then track everything (rates and all applicable fees) on a spreadsheet to easily compare lenders. Once you’re ready to apply, seek pre-approval from multiple lenders so you know exactly how much they are willing to lend you (keeping in mind these amounts can vary significantly as some lenders may invite you to spend more although not financially prudent to do so).

More on FHA loans

An FHA loan is a government-backed mortgage insured by the Federal Housing Administration, helping consumers—often first-time homebuyers—who have lower credit scores and lack the cash necessary to afford a 20% down payment. FHA loans are available in 15 and 30-year term options with fixed rates, and you can apply via FHA-approved lenders (assuming you qualify). While these loans are appealing to many, keep in mind you won’t be able to avoid paying two-part mortgage insurance: upfront (1.75% of your loan amount) and annually (paid monthly), which can range from 0.45% to 1.05% depending on the term you choose. If you put down less than 10% of your loan for a down payment, you’ll need to pay the annual premium for the entire life of the loan. The point is to stay aware of these additional expenses that can adversely impact your budget.

In sum: How much house you can afford

When you’re looking to buy a home, related circumstances are often extremely confusing. Perhaps you qualify for mortgages that just don’t work for your financial situation and/or are turned down for mortgages you technically have the capacity to pay for. Above all else, remember that lenders have strict guidelines for borrowers in order to ensure they don’t lose money on people who will never have the capacity to pay it back. While financial institutions do this to ensure they stay afloat, you can employ the very same approach with respect to your finances—never getting caught in a mortgage repayment plan that leaves you barely scraping by.

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Vision Retirement is an independent registered advisor (RIA) firm headquartered in Ridgewood, New Jersey. Launched in 2006 to better help people prepare for retirement and feel more confident in their decision-making, our firm’s mission is to provide clients with clarity and guidance so they can enjoy a comfortable and stress-free retirement. To schedule a no-obligation consultation with one of our financial advisors, please click here.

Disclosures:
This document is a summary only and is not intended to provide specific advice or recommendations for any individual or business.