If you are thinking about buying a house, you might wonder how much house can I afford? There is a significant distinction between what the bank will lend you versus what you can afford to pay. In general, a good rule of thumb is to pay less than 25% of your income toward your monthly house payment (i.e., mortgage plus HOA/condo fee). For example, if you earn $10,000 a month, try to pay $2,500 or less.
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Three Ideal Conditions
In the perfect world, you want to meet these three conditions for your home purchase:
- You can pay 20% down payment
- You plan to live there for more than 10 years
- Your monthly payment is less than 25% of your income
1. 20% Down Payment
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 require less than 20% down payment. Discuss these options with your Loan Officer. It might be worth moving forward with less than 20% down payment, if your mortgage payment is less than your current rent.
2. Plan to Live in the Home for 10+ Years
The 10 years condition helps 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 financial analysis to make sure that buying is right for you.
3. Payment is Less Than 25% of Income
Although lenders will approve you for a higher amount, less than 25% of your monthly income is usually a healthy amount. It gives you safety margin against ups and downs in live, unforeseen expenses, and allow you to do other things with your money (like saving and investing).
Four Rules of Thumb with Examples
There are several rules of thumb about how much your mortgage payment should be.
1. Home Price = Annual Gross Household Income x 3
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 3.
For example, if you earn $40,000 a year and your wife earns $60,000 a year, your household income is $100k, and you can afford a home that costs up to $300,000.
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.
2. Monthly Housing Expenses ≤ Monthly Gross Household Income x 28%
The second rule of thumb is to keep your monthly housing-related expenses (i.e., your 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. This is what we recommend above.
Continuing with the example above, your monthly income is $100,000 divided by 12, or $8,333 per month. Therefore, your monthly housing expenses should be less than $2,333 ($8,333 x 28%).
Using a mortgage amortization calculator, a $300,000 home with an interest rate of 4.25% on a 30-year fixed mortgage with an annual tax of $3,300 and insurance of $1,200 will cost you about $1,600 a month.
3. Monthly Housing Expenses + Debt Payments ≤ Monthly Gross Household Income x 36%
This rule looks at all of your debt obligations, including student loan payment, credit card debt payment, and any other debt that you have. This is your Debt-to-Income Ratio (DTI Ratio).
From the example above, 36% of $8,333 is $3,000.
This rule is an excellent 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 $1,500 left for your house payment. This means the $300,000 home is out of your reach.
This is why keeping your debt payments low relative to your income is essential.
4. Dave Ramsey’s Rule of Thumb
For an even more conservative approach, Dave Ramsey recommends:
Dave Ramsey recommends your housing payment, including property taxes and insurance, to be no more than 25% of your take-home income.
To maximize your savings, you should get a 15-year, fixed rate mortgage.
Additionally, he also recommends having a 20% down payment if at all possible, so you don’t have to deal with PMI.
Home Affordability Calculator
You can also use a calculator similar to the one below to estimate your monthly payment. Just adjust the price and down payment amounts to see the approximate monthly payment.
In addition to the methods above, you can 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, the lender will give you 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.
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 the necessary information about my wife and me (name, address, income, social security number, birth date), and about the property that we are looking at (loan amount, address, the purpose of the loan).
- Representative – That same night, a representative called me and verified several pieces of information (this took about 15 minutes).
- The 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 valid 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, a 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.
Just because your lender approved you for a $500,000 loan, it doesn’t mean 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?
I think the best answer is to simulate your homeownership 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 home improvements, maintenance, and additional utility costs, for a total of $1,800.
Are You Ready for a Home Payment?
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.
- You have no problem with the extra savings: This is great! You’re financially ready and the extra money saved can go toward your down payment or emergency fund.
- 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 home to become a financial barrier to achieving your other goals.
- You are struggling to save the difference consistently: You should reevaluate your homeownership goal and financial priorities. Here are some possibilities:
- Maybe a less expensive house is the answer, or
- You need to pursue a more frugal lifestyle, or
- 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 Bhulipongsanon 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®.