How to Figure out How Much House I Can Afford
Although purchasing a home can be an enriching and exciting experience, it can also be quite stressful. You need to consider numerous factors, including the location, proximity to social amenities like schools and hospitals, and ease of commute.
While all these things are essential to think about when buying a home, the starting point is always the cost of the house.
One of the most common mistakes that many prospective homeowners make is to purchase homes that they really can't afford, which inevitably lands them in long-term financial hardships.
Since buying a home is one of the most significant purchases you'll ever make, it is critical to ensure that you don't overstretch your financial capacity.
This means you have to determine how much house you can afford before you embark on a property search, particularly if you're planning to procure the property on a mortgage.
The Importance Of Following The 28/36 Law
If you're like most people, you may not be able to fully purchase a home out-of-pocket, which means you'll need a mortgage to help finance your home.
However, you don't want to end up with a mortgage you can't service since this will quickly put you in dire financial straits.
For this reason, you need to be smart about dividing your monthly income between your expected expenses while also allocating some room in your budget for any emergencies and unforeseen costs that may arise. That's where the 28/36 rule comes in.
The basic premise of this law states that:
Your cumulative housing expenses should not exceed 28% of your overall pre-tax income. This comprises your monthly principal and interest rate on your mortgage, your house insurance, mortgage insurance payments (PMI), and annual property taxes.
- Your overall debt shouldn't be more than 36% of your pre-tax income. As mentioned above, this covers the housing expenditures and credit cards, vehicle loans, personal loans, and school loans, as long as the monthly debt payments are projected to last for at least ten months. It is worth mentioning that other monthly expenses like current rent payments, food, gas, and utilities are not factored in here.
To illustrate how this would work in a real-life situation, let's suppose that you're earning $6000 a month. If you were to apply the 28/36 rule, you should not spend more than $1680 on housing expenses every month.
While it's not unrealistic for a renter who earns $6000 to spend $1680 on rent, the $1,680 should cover your mortgage insurance premiums and monthly mortgage payment if you're a homeowner making the same amount of money, and property taxes.
How To Determine How Much House You Can Afford
It would help consider various critical factors when calculating how much house you can afford. These are:
The amount of money you make significantly influences the kind of home you can afford and is generally used by mortgage lenders to determine what kind of loan you are eligible for.
Moreover, your gross monthly income sets a baseline of the amount of money you can afford to pay every month.
Gross monthly income is the total monthly revenue you and anybody else co-borrowing a mortgage loan receive from various sources.
In addition to any monthly income you earn from employment or business, your gross monthly income can be accumulated from other sources such as dividend earnings, part-time jobs, self-employment, royalties, pensions, and rental income.
Child support, alimony payments, sick pay, unemployment compensation, social security benefits, and income from trusts are also taken into account when calculating your income.
Some of the documents that are used to determine your income include:
- Copies of most recent pay stubs
- W-2 forms and tax returns
- Verification of employment
- 1099s (if you are self-employed)
You may be requested to explain any anomalies to your lender if your income is unpredictable because you have seasonal employment or are self-employed.
Debt-to-Income (DTI) Ratio
Your debt-to-income ratio is one of the main things that mortgage lenders look at when deciding whether or not to approve your mortgage application. Your DTI refers to the amount of your monthly gross income that goes toward paying your debts.
Having a DTI is as vital as having a good credit score or stable income when applying for a mortgage loan. A high DTI is one of the main reasons most prospective homebuyers end up having their mortgage applications denied.
Your debt-to-income ratio is calculated by dividing your monthly debt commitments by your monthly pre-tax or gross income. DTI often excludes monthly costs such as food, utilities, transportation, and health insurance, among other things.
Since DTI is a significant consideration when seeking home financing through a mortgage loan, keeping your DTI as low as possible is essential. Most lenders typically prefer a DTI of 36% for mortgage approval.
A good credit score is crucial when applying for a mortgage since it gives your lender a general idea of whether you can meet your credit obligations. Remember, your mortgage lender will be offering you a long-term loan of up to 30 years.
You will probably switch jobs, experience financial hardships, and watch the market change and evolve significantly during that time.
As such, your lender needs a baseline assurance of your willingness and capacity to repay the loan in full no matter what eventualities arise over the mortgage term.
With that being said, a good credit score is important for lenders and beneficial to your mortgage application in several ways. First, having a good credit score determines the kind of mortgage loan you are qualified for.
For instance, if you're looking to purchase a home through a conventional loan, you need to have a FICO score of at least 620, whereas if you're trying to secure an FHA loan, you require a minimum FICO score of 580.
Additionally, having a high FICO score allows you to secure better terms from your lenders. Not only are you able to buy more houses with the same downpayment, but you can enjoy lower interest rates.
Down payment refers to the amount you can pay upfront when purchasing a home and is one of the most critical factors determining how much home you can afford.
While most loans require a minimum down payment of 3%, the idea that you should aim for is a 20% down payment.
This down payment allows you to purchase equity in the home which essentially secures the loan. If you're unable to raise this down payment, on the other hand, you might have to seek alternative ways to secure the loan, through private mortgage insurance (PMI), for instance.
Most lenders will require mortgage insurance if you don't have the minimum down payment. Unfortunately, this means that you have to make mortgage insurance payments in addition to the regular monthly mortgage, so this may not be ideal if you are on a tight budget.
Nevertheless, choosing this option will require you to pay mortgage insurance until your mortgage value reaches 78 percent of the home value, at which point you will no longer need to make this payment.
You may be eligible for a zero down payment loan through VA or USDA programs, depending on your circumstances.
However, if you don't qualify for these programs and still can't make the minimum down payment out-of-pocket, you might not have any other alternative besides paying the extra PMI expense.;
The amount of interest rate that a lender offers you has a lot on how much home you can afford. A lower interest rate means lower monthly payments, making your mortgage more affordable.
So, even if the home you're planning to buy is on the higher end of your budget, securing low-interest loans can make the overall cost of the loan less expensive.
However, as highlighted earlier, whether or not you can qualify for a low-interest loan depends on your credit score.
In other words, the higher your credit score, the better your chances of getting a favorable interest from your lender.
It is worth bearing in mind that your interest rate may also be influenced by other factors such as your income and debt.
Apart from the aforementioned factors, there are several other costs that you'll need to be aware of when determining how much house you can buy. These include:
Property Taxes - If you own property in any state, you must pay property taxes. These are calculated by multiplying the assessed value of your property by the local tax rate.
Closing Costs - You will be required to pay closing costs after the home-buying process. Your lender will provide you with a closing cost estimate that includes the loan origination cost, appraisal fees, title search expenses, credit report fees, etc. Closing fees on a house purchase can range from 3% to 6% of the purchase price.
- Homeowners' Insurance - The cost of homeowners insurance is determined by where you live, the community you live in, and the sort of property you purchase. The value of your home, prospective rebuild expenses, and the value of your at-risk assets are all factors that are considered in homeowners insurance estimates. Contact an insurance agent if you'd like to get a general idea of what your homeowners' insurance might amount to.
How Much House Can I Afford With FHA Loans?
An FHA loan is a type of mortgage tailored to borrowers with lower incomes and credit scores. The Federal Housing Administration insures FHA loans (FHA) which means it will assist the lender in recouping their losses if borrowers cannot pay back the loan.
Consequently, mortgage lenders are willing and able to offer these loans to borrowers with low incomes and credit scores.
FHA loans allow you to put as little as 3.5 percent down payment on a home, making it a suitable alternative if a conventional mortgage 20 percent down payment is intimidating.
However, it would help if you remembered that paying such a low down payment may increase your monthly mortgage cost.
You can use a mortgage calculator to establish whether you can afford the monthly payments on an FHA loan.
Then, based on the cost of the property you want to buy and the down payment you want to make, you can determine how much house you can afford with an FHA loan.
How Much House Can I Afford Through VA Loans?
If you're a veteran or active US military member, you might be eligible for a VA loan. VA loans are specific mortgage loans that the US Department of Veterans Affairs backs.
When purchasing a home through a VA loan, you don't have to make any upfront down payment, and you can still be able to receive a mortgage even if your credit score isn't perfect.
However, you'll need to be cautious with a VA loan, just as you would with an FHA loan, to avoid taking on too large of a mortgage, especially if you're not putting any money down.
What Can I Do To Increase How Much House I Can Afford?
As previously discussed, how much house you can afford depends on your income, credit score, DTI, and the amount of money you are willing to put down on upfront payments.
The better your performance in the aforementioned criteria, the greater your chances of securing the kind of mortgage you're looking for.
Here are some ways you can increase the amount of mortgage you can afford:
Build Up Your Cash Reserves
Mortgage lenders are usually interested in knowing whether you'll have a cash reserve leftover following purchasing a home. For this reason, you are building your cash reserves both before and after buying a home is critical.
Putting money in the bank after purchasing a home is a smart method to avoid default and foreclosure.
It's the cushion that assures mortgage lenders that you'll be able to make subsequent payments even if your financial condition changes. They are more likely to offer you better terms and more significant mortgage amounts.
It's generally advisable to have enough money in your reserve to cover three months' worth of housing payments at the very least, but six months would be more ideal. This ensures you can still make ongoing monthly payments even if you lose your source of income temporarily.
Improve Your DTI Ratio
As previously highlighted, most lenders prefer to advance mortgage loans to borrowers who have low debt-to-income ratios.
When applying for a mortgage, it is recommended to maintain your DTI limit at about 36%. However, this can be pretty difficult to do if you're saddled with numerous debts for which you make payments every month.
If the debts you are carrying are hindering you from qualifying for a good mortgage, you essentially have two options.
First, you can consolidate your multiple debts into one single payment. This improves your credit score, but it may also lower the interest on your debt, hence reducing your monthly expenses.
Alternatively, you can improve your DTI by increasing your income. Assuming your debt obligations remain constant, increasing your earnings means you'll have more money left over even after making monthly payments on your debts.
Improve Your Credit Score
In many instances, a higher credit score enables you to receive not just a lower interest rate but also a considerably larger mortgage.
To improve your credit score, make all of your payments on time and avoid maxing out your credit cards or requesting extra credit while you're applying for a mortgage.
Put A Minimum of 20% On the Down Payment
You won't have to pay private mortgage insurance (PMI) if you put down at least 20% on a home, so you could be able to secure a bigger loan.
As highlighted earlier, PMI, which protects the lender if you default on your loan, is added to your monthly payment and can reduce the amount of money you can borrow.
If you have money left over after making a 20% down payment, you could pay your lender more money upfront to lower your interest rate even further.
Equipped with the understanding of how to determine how much you can afford on a home, you are definitely ready to embark on the property search and mortgage pre-approval.
There are plenty of home financing products offered in the market, including government-backed loans and conventional loans.
So, be sure to conduct your research to determine which mortgage is the best option for you.
With over 50 years of mortgage industry experience, we are here to help you achieve the American dream of owning a home. We strive to provide the best education before, during, and after you buy a home. Our advice is based on experience with Phil Ganz and Team closing over One billion dollars and helping countless families.
About Author - Phil Ganz
Phil Ganz has over 20+ years of experience in the residential financing space. With over a billion dollars of funded loans, Phil helps homebuyers configure the perfect mortgage plan. Whether it's your first home, a complex multiple-property purchase, or anything in between, Phil has the experience to help you achieve your goals.