If you want to purchase a home, you might wonder, “how much house can I afford to buy?” With the mortgage rates still close to its all-time lows and home values still below the peak, this may be a good time to buy.
But how can you figure out how much house you can really afford? How do you know that you’re ready for homeownership? As you consider your ability to buy a home, here are some methods that you can use to determine how big a mortgage you can take on:
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20% Down Payment + 10 Years
Before you even consider buying a home, I believe you should meet the following conditions: You should be able to make a 20% down payment from your savings, and plan to stay in the house for at least 10 years.
A 20% down payment will help you avoid paying Private Mortgage Insurance (PMI). If you do not have 20%, you should consider cutting your expenses and increasing your income to save up for the down payment before plunging into homeownership.
EXCEPTION: Note that there are loan options that requires less than 20% down payment. Discuss these options with your Loan Officer. If the mortgage payment ends up being about the same or less than what you’re paying in rent, it might be worth moving forward even if you have less than 20% down payment.
The 10 years portion is simply to help increase the likelihood that you will come out financially ahead after factoring in the costs of buying, selling, mortgage payments, and living in your home. If you plan to stay in your house for less than 10 years, consider renting or work with your Realtor and Loan Officer on a financial analysis to make sure that buying is right for you..
Photo by nikcname via Flickr
3 Rules of Thumb
Up to 4 Times Your Annual Gross Household Income
The first rule of thumb is to take your annual gross household income — basically, the money you and your spouse make in a year before taxes — and multiply that by 4. For example, if you earn $40,000 a year and your wife earns $50,000 a year, your household income is $90,000 and you can afford a home that costs up to $360,000.
This is a quick way of calculating how much you can afford, but the main problem with this rule is that it doesn’t take into account your other debts.
Housing Related Payments Less Than 28% of Your Monthly Gross Household Income
The second rule of thumb is to keep your monthly housing related expenses (mortgage payment which is the sum of principal + interest + real estate taxes + homeowner insurances and your monthly HOA/Condo fee) to less than 28% of your monthly household income.
Using the example above, your monthly income is $90,000 divided by 12, or $7,500 per month. Therefore, your monthly housing expenses should be less than $2,100 ($7,500 x 28%).
Using our mortgage amortization calculator, a $360,000 home with an interest rate of 4% on a 30-year fixed mortgage will cost you about $1,700 a month. This leaves about $400 for property taxes, insurance, and any HOA fee.
Total Debt Payment Less Than 36% of Your Monthly Gross Household Income
The third rule of thumb is similar to the one above, but this rule takes into account all of your debt obligations, including student loan payment, credit card debt payment, and any other debt that you have. From the example above, 36% of $7,500 is $2,700.
This rule is a nice way to double-check your ability to meet your obligations against the other rules. Say you make a $500 car loan payment a month, $250 student loan payment a month, and another $750 payment toward credit card debt. Once you add all that up, you only have $1,200 left for your house payment. This means the $360,000 home is out of you reach.
This is why it is important to limit your amount of debt with respect to your income before adding more debt — such as a mortgage — to your budget.
A second method of determining how much house you can afford is to go directly to the lender and ask for a loan pre-qualification. Many lenders have online applications that you can fill out in less than 10 minutes. After you fill out the pre-qualification application, a representative will call you for additional information and verification. Usually, you will be given the following information:
- the amount of loan that you are qualified for,
- the estimated interest rate (this rate is “floating”, meaning it is subject to change), and
- the estimated closing cost.
Also note that this process can result in a hard credit pull and will likely lower your credit score for about 3 months.
I recently went through this process with a lender to see if I would be able to qualify for a loan for an investment property on top of the mortgages that I already have. Here is the process I followed:
- Online – I filled out basic information about my wife and me (name, address, income, social security number, birthdate), and about the property that we are looking at (loan amount, address, purpose of the loan).
- Representative – That same night, a representative called me and verified several pieces of information (this took about 15 minutes).
- Result – Based on the information we provided, we are pre-qualified for a 30-year fixed-rate loan of $375,000 with a 4.75% interest rate. Our estimated closing costs are about $15,000.
The pre-qualification is good for 90 days (they issued a letter via email that I can show to the seller). However, the final loan approval is subject to sufficient proof of income and assets.
Of course, pre-qualification is not a guarantee that you can afford the mortgage payment and other housing costs. One of the reasons that we ended up with a foreclosure crisis is due to overly optimistic pre-qualifications. Don’t think for a minute that just because you were approved for a $500,000 loan that you can afford to repay it. Regardless of your approved loan amount, make sure you stay within your budget!
Simulate Your Mortgage Payment Experience
The problem with all the methods mentioned above is that they do not take your financial habits into account. So what is the best way to answer this question: How much house can I afford?
Personally, I think the best answer is to simulate your home ownership experience. Take your mortgage for a test drive! Say you’re paying $1,300 a month in rent today, and you’re looking at a $1,500 monthly mortgage payment. To be conservative, we’re going to add a 20% premium on top of the mortgage to account for homeowner’s insurance, real estate taxes, PMI, maintenance, and additional utility costs, for a total of $1,800.
Are you ready for a test drive?
It’s easy. Since you’re paying $1,300 in rent, all you have to do is save the $500 difference each month. The best way to do this is to put the money into a separate savings account that pays a decent interest rate. You should do this for at least a few months to see if you can adjust to the new lifestyle.
- If you have no problem with the extra savings — That great! You’re financially ready and the extra money saved can go toward your down payment or emergency fund.
- If you find yourself making compromises to hit the savings goal — You are going to be “house poor“. You should look for a less expensive house, find more ways to trim your expenses, or look for ways to increase your income. You don’t want your house to become a financial barrier to achieving your other goals.
- If you are struggling to consistently save the difference – You should reevaluate your homeownership goal and financial priorities. May be a less expensive house, or a more frugal lifestyle is the solution, or perhaps you can boost your income with a side hustle to afford your home. Or maybe it’s just not time for you to buy yet.
Buying and owning a home is an exciting experience, but it’s not always the right choice for everyone. For homeownership to be rewarding the house should be both physically and financially comfortable.
Pinyo is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.