Buying a house is exciting. The thrill of the hunt, at least initially, can be exhilarating. But the process of securing a home comes with its fair share of challenges.
One of the biggest challenges is deciding how much house you can afford. This essential step is the very first one you should take—well before you jump on Zillow and start compiling your list of dream pads.
Many factors come into play, such as your income, expenses, debts, and credit score. Therefore, it’s crucial to take an honest look at your financial situation to determine what you can comfortably afford.
By approaching the process practically, you’ll be able to find a home that fits both your financial situation and your lifestyle.
Do the math: 5 things to consider when estimating home affordability
- Location: where you want to live matters—a lot. Affordability varies based on your state (interest rates) and even your county (property taxes).
- What is your annual household income before taxes? If buying with a partner, include them. Deduct your mortgage interest and local property taxes to save money at tax time (especially when interest is high in the early years).
- How much of a down payment can you afford? Lenders prefer a 20% down payment, but it is possible to put less down. However, remember that means you’ll likely have to pay private mortgage insurance (PMI) to cover the added risk to the banks.
- How much are your monthly expenses? besides housing and everyday necessities like food? Include your minimum expenses for credit cards, car payments, student loans, child care, or alimony. Lenders have some leeway on how they factor in your total debt payments—depending on your credit score and payment history—but it’s best to consider realistic numbers here, not low-ball estimates that could put you in a financial bind down the line.
- What’s your credit score? A higher credit score gives you a better chance for a lower loan interest rate – which could save you thousands of dollars over time.
Follow the 28/36 rule
A common financial planning rule of thumb suggests spending less than 28% of your gross monthly income on housing expenses and less than 36% on total monthly debt (including housing expenses). Known as the 28/36 rule, this crucial guideline should be considered when searching for a mortgage.
Following the 28/36 rule can help you avoid taking on more monthly debt than you can handle and prevent you from becoming house poor.
While stretching your budget to secure that dream home may be tempting, getting in over your head with high monthly bills can quickly become stressful.
What’s a manageable monthly mortgage payment?
When evaluating your potential monthly mortgage payments, it’s crucial to understand the distinction between your “stretch” and “comfortable” spending capacity.
So what’s the difference between the two? As the name suggests, a comfortable spending capacity is more manageable and can limit undue financial stress.
On the other hand, if you stretch your monthly income to the point where you barely have enough left after making your monthly mortgage payment, you will likely struggle to cover your other expenses.
For example, suppose you can afford a payment of $3,500, but that only leaves you an extra $350 at the end of the month. In this case, you are probably stretching yourself too thin. Instead, factor in your myriad other financial responsibilities—they’re just as important as your mortgage payment.
What impact do current interest rates have on affordability?
The Federal Reserve increased interest rates several times throughout the past year to tame inflation. When this happens, mortgage interest rates rise, and people buy fewer homes. And when homebuyer sentiment is low, home prices drop.
If the high mortgage rates are manageable, it’s not a reason to abandon your home buying plans. Just remember that your monthly payments might be higher now than, say, in a year.
For example, let’s say you want to purchase a house worth $500,000. If we round off the current 30-year fixed rate to 7%, you’d be looking at a monthly payment of about $3,300. However, if interest rates drop to 5.5% in a year, your monthly loan payment would drop to roughly $2,800.
(Note: there is no guarantee interest rates will decrease; for illustrative purposes only.)
That’s an extra $500 a month, an additional $6,000 a year, and $180,000 more over the life of the loan to go toward other important things like saving for retirement or a child’s education.
Monthly payment calculated using Bankrate’s Mortgage Calculator
How does my debt-to-income ratio impact affordability?
When assessing your eligibility for a loan, lenders consider your debt-to-income ratio (DTI) to determine the level of risk involved in lending you money.
In simple terms, if your DTI ratio is high, the lender may question whether you can repay the loan. Therefore, when applying for a mortgage, it’s important to remember that lenders set maximum DTI limits that could impact your approval chances.
For example, lenders prefer DTI ratios below 43 percent for conventional loans. However, in some instances, the cutoff may be as high as 50%. So it goes without saying that reducing your DTI before applying for a mortgage is a good idea. To do this, pay off any recurring monthly debts such as credit cards, student loans, and car payments.
How to calculate your debt-to-income ratio
To calculate your debt-to-income ratio, divide your total monthly debt payments by your gross monthly income.
For example, if you’re spending $1,200 per month on debts and your gross monthly income is $4,000, your DTI is 30%.
Total Monthly Debt Payments / Gross Monthly Income = Debt to Income Ratio (DTI)
$1,200 / $4,000 = 30%
Final word
Knowing how much house you can afford is one of the most important pieces of the puzzle. By taking an honest look at your financial situation, you can find a home that comfortably fits your lifestyle.
Remember to consider all factors when calculating your affordability—including current interest rates and monthly expenses—and use the 28/36 rule as a guide so you don’t end up in a financial bind. Then you can confidently search for the house of your dreams without overstretching your wallet.
Buying a home is just one of the many facets of your financial life. To discover how a personalized plan can evolve with you through all of your life milestones, set up a call today.
