Reality Check: How Much House Can I Afford?
When you’re in the market for a new home, it may be tempting to try to buy the biggest or most expensive house that you can afford based on the number you find on your preapproval letter. However, the loan amount you qualify for doesn’t necessarily represent how much house you can afford.
What’s the best way to tell if you can afford that home? That’s right — find a mortgage calculator online. But, wait. Are you getting the right answer from that calculator? Worse, do you even have the right information to get that calculator to work for you?
And just because a mortgage lender is willing to give you a certain amount of money, doesn’t mean that you’ll be able to afford to pay it off in the end. Instead of taking a leap and suffering for it later, read through these tips to determine how much house you can afford on your budget.
How Do Lenders Determine How Much House I Can Afford?
Before you figure out how much house you can afford, it’s useful to know how lenders calculate whether you qualify for a mortgage. Mortgage lenders determine your qualification based on your credit score and debt-to-income ratio (DTI).
Your DTI enables lenders to evaluate your qualifications by weighing your income against your recurring debts. Based on this number, lenders will decide how much additional debt you’ll be able to manage when it comes to your mortgage.
To see if you will qualify for a mortgage, you can begin by calculating your DTI:
DTI = Total Monthly Payments / Gross Monthly Income
- Add all of the student loan, car loan, credit card, rent or house, child support, etc. payments you make each month to find your total monthly debt payments.
- Divide your total monthly debts by your gross monthly income. Your gross monthly income is the amount of money you make each month before taxes and deductions.
- Multiply the result by 100 to turn the decimal into a percentage.
Once you have calculated your DTI, you can evaluate whether it’s low enough to get approved for a mortgage. The lower your DTI, the more likely you’ll be to get approval.
If your total monthly debt is $850 (let’s say, $280 for your student loans + $380 for your car loans + $190 for your credit card debt), and your monthly income is $5,000 before taxes, your DTI would be 17%. A DTI of 17% is quite low, so you’d be likely to obtain a mortgage.
Very rarely will mortgage lenders give a loan to an individual whose DTI is above 50%. After calculating your DTI ratio, if you find that it’s over 50%, you’ll need to work on lowering it. The only ways to really improve your DTI are by increasing your income or paying down your debt.
Avoid The Pitfalls When Determining How Much House You Can Afford
When asking “how much house can I afford,” people tend to use two basic strategies. Most base their assessment on how large a loan lenders are willing to give them. But others use their current rent to determine how much they can afford to spend on monthly mortgage payments. The problem with these two approaches is that they tend to lead people to overestimate their budgets.
In order to know how much house you can afford, you not only need to think about how much you have saved but how much you will be spending. Although you’ll no longer be spending money on rent, you will have a slew of new payments that you need to consider, such as closing costs, property taxes, homeowners insurance and fees. And if the home you purchase needs work, you’ll also have to factor in the cost of home improvements.
‘How Much House Can I Afford’ Rule Of Thumb
When deciding how much house you can afford, the general rule of thumb is known as the 28/36% rule. This rule dictates that individuals should avoid spending beyond 28% of their gross monthly income on housing expenses and 36% on their total monthly debt payments.
So 28% represents the highest possible front-end ratio, which is the largest percentage of your income that should be allotted to mortgage payments. And 36% represents the highest possible back-end ratio, also referred to as the debt-to-income ratio, which you now know is the percentage of your income that is set aside to pay off debt.
Before calculating “how much house can I afford,” it’s necessary to have a firm grasp of what falls into the category of housing expenses. These costs are the various components of your monthly mortgage payment, which are often referred to as the PITIA:
- Principal: This portion of the payment goes towards paying off the money that was borrowed to purchase the house.
- Interest: This portion is the fee that the lender charges you for borrowing the money to purchase the house.
- Taxes: This portion is the property taxes that you pay to the local government based on the value of your house. These real estate taxes are used to pay for local infrastructure, improvements, municipal salaries, etc.
- Insurance: This portion is your homeowners insurance that covers your house in case any damage occurs. Lenders require you to pay this insurance to protect their (and your) investment from any potential unforeseen disasters.
- Association Dues: This portion is the fee that you pay if your house is part of a homeowners association. If your home is not a part of a homeowners association, you will not have to pay this fee. However, if you do, this money will go towards maintaining the community your home is in as well as paying for any of the amenities that may be offered with your home.
So to determine how much house you can afford, you should do the following calculations:
(Gross Monthly Income x 28) / 100 = Maximum Monthly Housing Expenses
(Gross Monthly Income x 36) / 100 = Maximum Total Monthly Debt Payments
So for a gross monthly income of $5,000, you shouldn’t spend more than $1,400 on housing expenses and $1,800 on debt payments each month.
Now, $1,800 may seem relatively high, but don’t forget, you still have to factor in the debt payments that you’re already making. So, $1,800 - $850 = $950. That means you’d be able to afford a monthly mortgage payment of $950.
How To Look Beyond The Monthly Mortgage Payment
So given the “how much house can I afford” rule of thumb, you now know that you can afford a monthly mortgage payment of $950. But that’s only so helpful. You’re still probably wondering, how much house can I afford?
Well, the answer depends on how much money you’ve saved. When you buy a house, you’re going to need money upfront for closing costs and a down payment.
Closing costs are the fees associated with finalizing your loan, including application, origination, appraisal, credit report, title and attorney fees. Closing costs typically run about 5% of the purchase price of your home.
When obtaining a mortgage, you also have a down payment on your house, which is the money that you pay upfront. The good news is that this sum is subtracted from your total mortgage amount. So the more money that you set aside for your down payment, the less you’ll have to spend each month on mortgage payments.
The cost of your down payment will vary based on the purchase price of your home and the type of loan that you obtain. Conventional loans require borrowers to pay a more significant percentage of the purchase price upfront than do government-backed mortgages.
Conventional loans typically require a down payment of 5-20% of the purchase price. Yet, if you put down less than 20%, your lender will require you to pay private mortgage insurance (PMI) fees to safeguard the mortgage company in the event that you default on your loan.
Government-backed loans, such as FHA, VA and USDA loans, provide borrowers with some relief when it comes to down payments. FHA loans require borrowers to put down only 3.5% of the purchase price, while VA loans enable veterans and USDA loans enable low-income earners to obtain mortgages without any down payment. However, you must be eligible for these loans in order to reap the benefits.
How Does The Down Payment Affect How Much House I Can Afford?
It’s crucial to consider your down payment when figuring out how much house you can afford because the money you put down will drain a considerable amount of your savings. If you use up your savings on a down payment and have earmarked too much of your income for paying off your mortgage and other debts, you’ll find yourself in serious financial trouble should any emergencies or unforeseen expenses occur.
Although down payments can be lower than 20% of the purchasing price, you should really try to stay as close to that number as possible. You don’t want to get stuck paying PMI fees. But more importantly, you need to remember that the less you put down now, the more you’ll have to spend each month on your mortgage payments.
Mortgage Affordability Calculators
As you continue to ponder “how much house can I afford,” you may realize that it’s a struggle to keep in mind all the factors that go into determining the answer. To help you figure out how much house you can afford, we’ve created a Home Affordability Calculator.
After you plug your annual income, monthly debt, savings, zip code and credit score into the calculator, it will quickly compute the maximum home price you can afford. Plus, it will also list an appropriate mortgage option that will enable you to finance your home.
Once you know how much house you can afford, you can then use the Mortgage Calculator to see how your down payment will impact your monthly mortgage payments. Playing around with this calculator will enable you to see how putting down specific dollar amounts or percentages of the purchase price can make your monthly payments more or less affordable.
And unlike other versions, this mortgage calculator presents not only the costs associated with your principal and interest but also your property taxes and homeowners insurance. So you can get a full picture of what your monthly payments ultimately will include.
Words To Remember When Determining How Much House You Can Afford
Although you may be inclined to buy a house priced in line with the maximum loan amount a lender is willing to give you, remember that’s not the wisest decision.
When Dennis Spensley, Triple Crown Mortgage Banker at Quicken Loans®, works with clients, he makes sure that they understand precisely what they’re getting into. “I explain the debt ratios that we work off of, but I also let them know that what we’re comfortable with and what they’re comfortable with may be two different things,” he says.
“They will be writing the check every month to us, and if they are not comfortable with the payment, I tell them that they should either lower their max purchase price or if they cannot find something in a lower price range, they should continue to rent,” Spensley adds. “I let them know that ethically, I do not want to be responsible for putting them into a bad loan.”
Just because a mortgage lender offers you a certain amount of money, doesn’t mean you should take it. Instead of maxing out your budget and buying a house that may cause you financial distress in the future, you should choose a home that meets all your needs but costs the least amount. Read our other resources on the home buying process and what makes the most sense for your needs.
Table of Contents
Debt-To-Income Ratio: How To Calculate DTI
Home Buying - 13-minute read
Debt to income ratio (DTI) is a critical factor in qualifying for a loan. Learn what DTI is, how it’s calculated, and why it’s so important to financial health.
How To Save For A Down Payment
Home Buying - 6-minute read
Saving for a down payment today isn’t as difficult as you might think. That’s because lenders offer several loan options that require smaller down payments. And the smaller the down payment, the easier it is to put together the money you need for it.
What's The Real Cost Of Buying A Home?
Home Buying - 15-minute read
We’d be lying if we didn’t acknowledge that buying a home can be a significant investment both up front and over time. If you’re considering taking the financial plunge into homeownership, here are the costs you should expect going into the process.