Buying a house is exciting. The thrill of the hunt, at least initially, can be exhilarating. However, the process comes with its fair share of challenges, and it's completely normal to feel a bit overwhelmed by the financial reality of it all. Before you jump on Zillow and start compiling a list of dream pads, let's take a practical, honest look at your finances to ensure you find a home that fits your life without overstretching your wallet.
Do the math on the 5 key factors
When you're estimating affordability, it's about more than just the sticker price. Here are five things you need to consider to get the real picture.
Location matters
Where you want to live changes the math a lot. Affordability varies based on your state, which affects interest rates, and even your county, which dictates property taxes.
Your annual household income
Look at your income before taxes. If you're buying with a partner, include them too. You should also remember that deducting mortgage interest and local property taxes can help save money at tax time, especially in the early years when interest is high.
Your down payment
Lenders generally prefer a 20% down payment. It is possible to put less down, but remember that usually means you'll have to pay private mortgage insurance (PMI) to cover the added risk to the banks.
Your real monthly expenses
We're talking about more than just housing and food. You need to include minimum expenses for credit cards, car payments, student loans, child care, or alimony. Lenders have some leeway on how they factor in total debt payments depending on your credit score, but it's best to use realistic numbers so you don't put yourself in a bind later.
Your credit score
A higher credit score gives you a better chance for a lower loan interest rate. Over time, that lower rate could save you thousands of dollars.
Follow the 28/36 rule
To avoid becoming "house poor," you can use a common financial planning rule of thumb known as the 28/36 rule. This guideline suggests you should spend less than 28% of your gross monthly income on housing expenses and less than 36% on total monthly debt, which includes your housing expenses.
Following this rule helps you avoid taking on more monthly debt than you can handle. While it's tempting to stretch your budget to secure a dream home, getting in over your head with high monthly bills can quickly become stressful.
Find your comfortable monthly payment
When you look at potential mortgage payments, it's crucial to understand the distinction between your "stretch" capacity and your "comfortable" spending capacity. As the name suggests, a comfortable capacity is manageable and limits undue financial stress.
If you stretch your monthly income to the point where you barely have enough left after making your mortgage payment, you'll likely struggle to cover 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're probably stretching yourself too thin. You need to factor in your myriad other financial responsibilities because they are just as important as your mortgage payment.
Check the impact of interest rates
The Federal Reserve increased interest rates several times throughout the past year to tame inflation. When this happens, mortgage rates rise. If the high mortgage rates are manageable for you, it's not a reason to abandon your plans, but you must remember that monthly payments might be higher now than in the future.
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.
That difference is an extra $500 a month, an additional $6,000 a year, and $180,000 more over the life of the loan. That is money that could go toward other important things like saving for retirement or a child's education.
(Note: there is no guarantee interest rates will decrease; this is for illustrative purposes only. Monthly payment calculated using Bankrate's Mortgage Calculator.)
Calculate your debt-to-income ratio
Lenders look at your debt-to-income ratio (DTI) to determine the level of risk involved in lending you money. In simple terms, if your DTI is high, the lender may question whether you can repay the loan.
Lenders prefer DTI ratios below 43 percent for conventional loans. In some instances, the cutoff may be as high as 50%, but it goes without saying that reducing your DTI before applying is a good idea. You can do this by paying off recurring monthly debts like credit cards or student loans.
How to calculate it
Divide your total monthly debt payments by your gross monthly income.
- Formula: Total Monthly Debt Payments / Gross Monthly Income = DTI
- Example: If you're spending $1,200 per month on debts and your gross monthly income is $4,000, your DTI is 30%.
The Facet difference
Knowing how much house you can afford is a massive piece of the puzzle, but buying a home is just one of the many facets of your financial life. At Facet, we believe your financial advice should be as dynamic as your life is. We offer a refreshing flat-fee membership that gives you access to a team of CFP® professionals who act as your fiduciary.
We don't just look at the mortgage; we look at how that home fits into your retirement goals, your tax strategy, and your everyday cash flow. Facet is not an attorney and does not provide tax or legal advice. Consult a qualified tax or legal professional regarding your specific situation.
By taking an honest look at your whole financial situation, we help you build a roadmap that allows you to confidently search for the house of your dreams without overstretching your wallet.
