Purchasing a home could be the most expensive personal investment you’ll ever make. Figuring out how much you can afford is a crucial aspect of the home buying process. How much home you can afford comes down to several factors, and how much the bank is willing to lend is just one of them. Too many people end up with a mortgage payment they cannot afford which can ruin your financial standing for years to come.
Here’s everything you need to consider in order to determine just how much house you can feasibly afford.
Factors that Impact House Affordability
As a general rule of thumb, you can afford to finance a house that costs between 2 and 2.5 times your gross yearly income. But this is just a general guideline, and it doesn’t always work perfectly for everyone.
Fortunately, the general rule of thumb isn’t the only affordability tool at your disposal. To calculate how much house you can afford, you'll need to take your household income, debts, and down payment into account. You don't want to struggle to pay your monthly mortgage payment, which is why you need to consider your overall financial health before you make any decisions.
Another rule of thumb is to have at least three months of expenses, including your mortgage payments, in reserve before purchasing a house. Keep in mind that monthly mortgage payments include interest, taxes, and insurance in addition to your principal.
Also, it’s good to know how much your bank thinks you can afford and how it came to that estimation. Knowing this will help you weigh how comfortably you can afford the anticipated mortgage.
With that said, here are a few key things you should factor in when looking for the best solution:
- Your gross monthly and annual income
- Your current monthly debt and expenses
- Credit card debt
- Loans (personal, auto, and student)
- Child support
- Property taxes and insurance
- Loan amounts, Interest rates closing costs
How to Calculate Affordability
You can use your debt-to-income ratio (DTI) to calculate how much mortgage debt you can take on. The DTI ratio determines the percentage of monthly income that should be dedicated to paying off debt. Most lenders recommend a DTI ratio of 36%. This means that when you add up your monthly debt and divide it by your gross monthly income, it should not exceed 36%.
If you have a high credit score, you might qualify for a higher DTI ratio. However, it’s advisable to follow the 28/36 percent rule.
Ideally, you shouldn’t spend more than 28% of your gross monthly income on household expenses and no more than 36% on all debt, including credit cards, student loans, and auto loans.
That said, here’s how you can determine how much house you can afford.
1. Know Your Credit Score
Your credit score determines which loans you qualify for and how much down payment you’ll need. It will influence your lender’s view of you as a borrower.
The minimum credit score required varies depending on the type of loan you take out. Credit scores typically range from 300 to 850 and while you don’t need a perfect credit store to qualify for a mortgage, the better your score, the less you will pay over the course of your loan.
2. Plan for a Down Payment and Closing Costs
How much have you actually saved-up for a down payment and closing costs? Bigger down payments often mean better mortgage rates as lenders will have more faith in your ability to pay back the loan. You can always refinance your mortgage into a lower rate later, provided the market conditions are favorable. However, having cash available in a savings account in anticipation of making a down payment on your new mortgage gives you a lot more buying power. The amount you need for the closing costs must also be determined. Closing costs are funds you will need to obtain financing for the home purchase.
The amount of money you should save, depends on the type of mortgage you want, the lender you choose and obviously, your current financial situation. Saving enough money for a down payment on a house is one of the biggest hurdles but it can also bring you some of the greatest rewards long-term.
3. Choose the Right Loan Option for You
How much house can you afford with a Conventional loan vs. an FHA loan vs. a VA loan?
Conventional loans are the most common and well-known loan. This loan is backed by private lenders such as a bank or credit union. Conventional mortgages allow a down payment as low as 3%, however, you will need to be in good standing with your credit score. While you will be required to have private mortgage insurance (PMI) with a lower down payment, you can remove this once you reach 78% equity. In addition, this loan is available for a second home or investment property.
FHA loans have less rigid qualifying standards making them an excellent option for first-time home buyers and those with lower credit scores. And you can get a house with at least a 3.5% down payment, but PMI will be included for the life of the loan.
Reserved for veterans and their families, a VA loan doesn’t require a down payment but does require that the borrower be a current or veteran military service member or eligible spouse.
Have you considered your options when it comes to qualifying for a first-time buyer loan? And, what’s the difference between a fixed rate vs. an adjustable-rate mortgage loan? Knowing your loan options can save you in the long run and just might open the door to possibilities you didn’t even know were available. The more educated you are, the better.
The Bottom Line
The right answer to the question, “How much home can I afford?” comes down to you as an individual. Regardless of income, no two people lead the same lifestyle, have the same goals, or fall into the exact same financial category.
Remember, always do your due diligence. Don’t take on such debt without taking the time to crunch the numbers and make a plan that best suits the needs of your family with your financial goals in mind.