After graduating from college, and getting a job, it’s just a matter of time before most people start thinking about home ownership. But before you jump into the biggest purchase of your life, it’s important to ask, how much house can I afford?
Once you’ve signed the closing papers on a home purchase, the mortgage bills begin...and they won’t be going away. And if those payments are too high, your “dream” home can quickly become a financial nightmare.
So how can you make sure that your home budget is where it needs to be? Here’s how to calculate how much house you can afford.
If you just want to see what you're qualified for, check out Credible Mortgage here and get started >>
Mortgage Affordability Rules Of Thumb
When you’re trying to determine how much house you can afford, there are two main rules that many mortgage experts recommend.
First, you should typically avoid buying a house that costs more than three times your annual income. So if you earn $60,000 per year, your house should be worth $180,000 or less when you buy it.
Second, consider following the 28/36 rule. According to this rule, no more than 28% of your income should go towards a mortgage payment (including taxes and insurance) and 36% towards total debt repayment.
So if you earn $5,000 per month, you’d want to keep your monthly mortgage payment below $1,400. And you’d want to keep all debt payments (including mortgage, car payments, student loan payments, credit card payments, etc.) below $1,800.
How Much House Can I Afford According To The Banks?
When you’re buying a house, the bank is going to take a long, hard look at three important numbers. Those numbers are:
Debt-to-income ratio: Your debt-to-income (DTI) ratio is the ratio between your monthly debt payments and your income. Your total DTI needs to be below 43% to qualify for a mortgage while a DTI below 36% is considered ideal.
Credit score: A higher credit score means a lower interest rate. A lower interest rate will translate to lower monthly payments. Learn how to raise your credit score.
Loan to value: The LTV is the ratio of the amount you owe compared to the value of the house. An 80% LTV means you put down 20% when you bought the house. Over time, your LTV will fall as you pay off your loan and the home value increases.
How Much House Can I Really Afford?
The numbers listed above will tell you how much mortgage you may be able to get approved for. But borrowing up to that limit could be a bad idea.
When a lender uses a mortgage calculator, they're just trying to protect themselves from default. But the amount of money that your bank is comfortable with giving you could still put a strain on your budget. For your own mortgage calculator, focus on these numbers instead.
Your down payment requirement: The amount you put down on a house influences the fees you pay, your interest rate, and your monthly payment. In general, bigger down payments mean lower fees and lower interest rates. By putting 20% down, you can avoid Private Mortgage Insurance (PMI). But if you can’t, you can still get into a house with a 0% to 5% down payment with certain mortgage types.
Your monthly payment: A monthly mortgage payment will include the loan cost, taxes and insurance. This is the key number to understanding a home’s affordability for you. In general, you’ll want to keep your mortgage payment in line with your rent payment. Of course, some people live with parents or friends to keep rent low, so they can save, invest and pay off debt. If that’s you, just consider how much you think you can afford month to month before blindly accepting what a lender suggests you can afford.
Your monthly take-home pay: The bank's mortgage calculator cares about your gross income, but you’ll pay your mortgage with the money you take home. Your lender may think you can easily handle a $1200 mortgage payment with your $48,000 annual salary. But if you usually take home just $2300 per month after taxes, health insurance, and a 401(k) contribution, you may struggle to make the payment.
Should You Ever Buy A Home At The Top-End Of Your Budget?
Many mortgage brokers and realtors may encourage to buy a house at the top-end of their budget. But here are a few reasons to consider buying a less expensive house.
- Owning a house is expensive. Home ownership is more than mortgage, insurance and property tax costs. You’ll also pay for ongoing maintenance and possibly big repairs. These are costs renters don’t often consider. With these new costs, you may want to be conservative when buying a house.
- Smaller monthly payments. A less expensive house means a smaller monthly payment. That leaves extra room for saving and investing.
- Easier to afford on a single income. Many people look to buy a house before a new baby arrives. Even if both partners plan to go back to work, life changes. If you’re part of a couple, you may want to buy a place that you could afford on a single income.
- The bank’s budget isn’t your personal budget: The bank mortgage calculator doesn’t consider taxes, daycare bills, or other monthly expenses when it calculates the amount of house you can afford. Your monthly mortgage payment needs to fit comfortably within your budget for the new house to work.
There are times, however, when buying near the top of your pre-approval range could be a safer decision. First, if you plan to rent out rooms that could significantly change the equation.
If you earn $40,000 per year, a $1200 per month mortgage payment may be too high. But if you rent out two rooms for $500 each, you’re left with $200 to pay on your own. As long as you follow through on renting out the rooms, it can make a ton of sense.
Second, if you reasonably expect to earn more soon that could change how you think about mortgage affordability. Career and income growth can be difficult to predict.
However, people working in certain sectors may be able to reasonably predict big earnings increases over the next few years. If you're sure a big raise is imminently coming your way, it may make sense to buy towards the top-end of your budget.
How Much House Can I Afford With Each Type Of Mortgage?
Finding the right mortgage for your house can be difficult. But here are a few of the major mortgages to consider when you’re shopping for a house.
Conventional Mortgage: A conventional mortgage is a mortgage that is guaranteed by Fannie Mae or Freddie Mac. You generally need a 5% down payment, and a 620 credit score to take out a conventional mortgage. That said, first-time home buyers may qualify for a 3% down payment program if they meet income requirements. If you put down less than 20%, you’ll need to pay PMI each month as well.
FHA Mortgage: An FHA mortgage is guaranteed by the Federal Housing Administration. This loan requires a 3.5% down payment, and is available for borrowers with credit scores as low as 580 (or a 500 credit score for borrowers who can put 10% down). Buyers do have to pay an upfront funding fee and ongoing mortgage insurance premiums (MIP). However, the interest rate on FHA loans is subsidized, so the overall cost tends to be on par with the rates from conventional loans.
VA Mortgage: VA mortgages are a benefit provided to military service members and their families. These loans allows a 0% down payment and have no ongoing insurance fees. Borrowers will need to pay an upfront funding fee. But that fee can be financed which can truly make this a $0 out of pocket loan.
Jumbo Mortgage: People buying in expensive areas may not qualify for typical mortgages like those listed above. In that case, a jumbo mortgage may make sense. These are loans for properties ranging from $800,000 to $5 million. They usually require great credit scores (in the high 700s), a large down payment, and a strong income.
A home can be a very emotional purchase. After spending only five to ten minutes on a house tour, it's easy to “fall in love” and feel like we simply must have it no matter what.
That’s a totally human reaction. But it's also why it’s so important to know your budget before you start house hunting. Honestly thinking through “How much house can I afford?” today can help you avoid buying too much house tomorrow.
Once you've used the mortgage calculator to determine your mortgage affordability, you'll want to shop your mortgage with several lenders to make sure you get the best rate. Start your mortgage-shopping process by checking out our list of the top online mortgage lenders.
Robert Farrington is America’s Millennial Money Expert® and America’s Student Loan Debt Expert™, and the founder of The College Investor, a personal finance site dedicated to helping millennials escape student loan debt to start investing and building wealth for the future. You can learn more about him on the About Page, or on his personal site RobertFarrington.com.
He regularly writes about investing, student loan debt, and general personal finance topics geared towards anyone wanting to earn more, get out of debt, and start building wealth for the future.
He has been quoted in major publications including the New York Times, Washington Post, Fox, ABC, NBC, and more. He is also a regular contributor to Forbes.