Buying a home is a major decision that will affect your finances for the next 15 to 30 years.
Figuring out how much house you can afford helps you stay within your price range when looking for a new home. It also ensures you don’t get stuck with a mortgage you can’t afford. They also affect your ability to get a mortgage and influence the interest rate on your home loan.
Determining how much house you can afford starts with a thorough examination of your finances. You’ll need to tally up your household income, your monthly debt payments, your living expenses, and your savings.
How Big a Mortgage Can I Afford?
As a general rule of thumb, you can afford a mortgage that is 2 to 2.5 times your gross income. Ultimately, your income, debts, assets, and liabilities determine how much house you can afford. Your down payment and credit history impact your ability to get a mortgage and the interest rate you pay.
The 28/36 rule is a rule lenders often use to determine how big a mortgage you can afford.
What Is the 28/36 Rule?
The 28/36 rule determines the maximum amount of your pre-tax income you should spend on housing and debt payments. The 28/36 rule states that your housing expenses should not exceed 28% of your gross monthly income, and your debt payments should not exceed 36% of your gross monthly income.
Two core principles make up the 28/36 rule:
- Your monthly housing costs should not exceed 28 percent of your monthly pre-tax income. Your housing costs include taxes and insurance. The ratio of housing expenses to income is often called your housing expense ratio or PITI ratio, which stands for principal, interest, taxes, and insurance.
- Your total debt payments should be no more than 36 percent of your gross monthly income. Debts include your mortgage, credit card debt, student loans, and other personal loans. The sum of your debts divided by your monthly gross income is your debt-to-income ratio or DTI ratio.
After reviewing your household income and expenses, you might have difficulty getting a mortgage if you find that you’re over one or both of these percentages. You might want to focus on increasing your annual income or lowering your monthly housing costs and reducing other monthly expenses before you go shopping for a new home.
Suppose your housing expense ratio and your DTI ratio fall within these guidelines. In that case, there are still several additional factors involved with qualifying for a mortgage and working out how much house you can afford.
Factors Affecting How Much House You Can Afford
In addition to your housing costs to income ratio and your debt to income ratio, which are major factors, several other things affect how much house you can afford.
Consider the following before you start house hunting:
Mortgage Term Length
Your mortgage term is the amount of time you have to pay back your loan. The most common home loan terms are 15 and 30 years.
Your mortgage term has a significant impact on your monthly payment. For example:
If you buy a $200,000 house with a 30 year fixed rate mortgage at 3.5%, your monthly payment is $898, excluding taxes and insurance. The total cost of your mortgage is $323,312.
If you buy a $200,000 house and go for the shorter term with a 15-year fixed-rate mortgage at 3.5%, your monthly payments, excluding taxes and insurance, are $1,430. The total cost of your mortgage is $257,358.
A 15-year mortgage saves you money over the life of the loan but comes with higher monthly payments.
After your mortgage application is approved and you close on your home loan, your monthly mortgage payment will likely be your largest monthly debt payment. It’s vital to ensure you can afford it.
Your potential monthly mortgage payment is the most significant determining factor in how much home you can afford.
Your mortgage rate is the interest rate you pay on your mortgage. Lenders set mortgage rates, and rates can be fixed or adjustable, meaning they can stay the same or fluctuate over the life of the loan.
Interest rates vary by lender. The rate you get depends on your credit score, the size of your down payment, and other factors.
Suppose you buy our example $200,000 home with a 15-year fixed mortgage as above. But you change the mortgage interest rate from 3.5% to 4%. Your payment goes up from $1,430 to $1,479. With a half a percent increase, the total cost of the mortgage goes from $257,358 to $266,288.
Slight differences in mortgage rates might seem insignificant, but they can add up to thousands of dollars in interest over the term of your loan. Your mortgage rate also affects your monthly payment, which largely determines how much you can afford to spend on a new home. For these reasons, it’s essential to shop around for the best rate.
Your credit score is a critical component of the homebuying process. Your credit history affects whether you qualify for a mortgage, what type of loan you can get, and your interest rate.
You generally need a credit score of 620 or higher to secure a mortgage loan, as that’s the minimum score most lenders will consider for a conventional loan. It is possible to get a mortgage with a lower score, however. Other types of mortgage loans through government-backed programs like FHA loans or VA loans allow credit scores in the 500s.
Check your credit before you start the mortgage application process. Get your credit report from each of the big three credit bureaus: Equifax, Experian, and TransUnion. You can get a free copy of your report from each agency through AnnualCreditReport.com.
Review your credit history for incorrect information and address mistakes as soon as possible. Alert the credit reporting agency immediately if you find any mistakes. You might need to provide proof of payment or other supporting documents, like a police report, in the event of identity fraud.
You don’t need a perfect credit rating, but having bad credit makes buying a house harder and costlier. If your credit score prevents you from getting a mortgage, work on cleaning up your credit and getting out of debt.
Make more than the minimum payment to pay off your credit cards as quickly as you can. Make your student loan payments, car payments, and other debt obligations on time. See what you can cut from your budget, then put the money your free up toward retiring your non-housing debts faster.
In general, a mortgage lender prefers a down payment of at least 20% of the purchase price in cash. You can still get a conventional loan putting down as little as 3%. However, a lower down payment often comes with the additional expense of private mortgage insurance (PMI) and higher monthly mortgage payments.
If you put down less than 20%, plan on paying mortgage insurance premiums for at least a few years until you reach 20% equity. How much you pay for PMI depends on your credit score, the potential for property appreciation, the size of the home, and other factors. According to an Urban Institute report, the average cost of private mortgage insurance ranges from 0.58% to 1.86% of the loan amount annually.
A higher down payment coupled with a better credit score means:
- Lower monthly mortgage payments
- A lower PMI rate
- Fewer years of paying PMI
- Paying less interest for the life of the loan
Putting down 20% of the purchase price is a financially sound idea if it’s possible.
Between a down payment, closing costs, appraisal fees, and other related expenses, the money you need upfront for a new home can eat up your savings. Some mortgage lenders will require having at least two months of mortgage payments in reserve. More is better for lenders and your peace of mind.
An emergency fund consisting of six months of mortgage payments and living expenses in the bank is a good goal. It could prevent you from having to give up your home if something unforeseen happens or your financial situation changes. You don’t want a job loss, a salary cut, or unexpected expenses forcing you out of your house.
Closing costs can affect how much house you can afford. They typically cost you between 2% and 5% of the purchase price.
If you pay for closing costs in cash, that might mean you have less for a down payment. You might have to look at less expensive houses with a smaller down payment. If you elect to finance your closing costs by adding them to your mortgage principal, that could also mean buying less home.
Getting the seller to agree to pay closing costs without raising the purchase price would be ideal. You may be able to get that in a buyer’s market or from a motivated seller.
When you own property, you pay property taxes. Your property taxes are calculated based on the assessed value of your home multiplied by your local property tax rate.
A solid idea of how much you’ll owe in property taxes is helpful. Go over real estate listings in the area where you’re buying and check the county assessor’s website. The assessment can be much lower than the market value due to homestead and other tax exemptions, as well as your county’s annual property tax assessment rate.
Homeowners insurance typically covers damage to the home, damage to personal property during an insured event, and injuries that occur on the property. Proof of insurance will likely be required when applying for a mortgage, so be sure to factor it in when you’re determining how much house you can afford.
Homeowners Association Fees
HOA fees vary widely depending on the type of home, where you live, and what expenses your HOA dues cover. A monthly HOA fee could be $50 or over $1,000.
Find out how much the HOA fees are for any community where you’re considering buying. You should be able to find this information by checking real estate listings online for the neighborhood or building you’re considering.
You have to pay your HOA fees when you buy a home. Factor them in when you’re figuring out how much home you can afford.
Maintenance and Upkeep
Home maintenance is costly and one of those ongoing costs that all homeowners face. You might need to replace the roof, get new siding, or repair your heating and cooling system. Lawn care, pest control, snow removal, and other routine maintenance tasks cost money as well.
Allocate at least 1% of your home’s purchase price to your home maintenance budget each year. The bigger or older your house, the more you should put aside in your monthly budget for upkeep. You might not spend it all every year, but you probably will at some point.
Utility bills for your future home could cost significantly more than you’re paying now. That’s especially true if you currently live in an apartment with utilities included or live in a smaller home than the one you’re buying.
Talk to your real estate agent or people who live in the area. Get an idea of what electricity, gas, water, and trash pickup cost.
Your monthly expenses play a big part in how much house you can afford. Lenders don’t look at how much you spend on living expenses like groceries, clothes, or entertainment every month, but you should so you know what you can afford.
Also, consider that your living expenses are likely to change when you buy a new home. In addition to your housing budget, things like gas, food, and car insurance may also vary based on your new location.
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