The first place to start when considering how much home you can afford is to ask yourself what is the most you want and can afford to pay for a total mortgage payment each month. If you’re currently paying $2000 a month and you know you don’t want to increase your monthly housing expense, then you have a place to start, but it doesn’t stop there.
This article discusses the factors that influence how much home you can afford including:
The 29/41 Rule
Interest Rates and Loan Terms
Down Payments
Cash Reserves
Additional Costs
Determine your budget and how much home you can afford using the 29/41 rule.
The 29/41 rule refers to an ideal maximum percent of your gross (pre-tax) monthly income that you should spend on housing (29%) and repaying debt (41%). These are two important factors lenders consider when you apply for a loan and how much financing you can receive:
Housing Expense: The percentage of your pre-tax monthly income that goes toward a mortgage payment/housing expense. In an ideal world, lenders want to see your housing expense at 29% or less of your gross monthly income. You are not limited to this amount. It’s simply a safe recommendation.
Debt-to-Income Ratio: The percentage of your pre-tax monthly income that goes toward paying your monthly debts (ex: mortgage, car loans, student loans, credit cards) A DTI of 41% is ideal, but you can get a loan with a higher debt-to-income ratio. DTI is something that can stop you from getting a loan. It’s a big deal. There are steps you can take to improve your DTI.
Note: 29/41 is not a hard and fast rule. It’s a guideline.
There are other factors which may allow for a higher DTI. Some people who max out their monthly mortgage payment at a higher percentage of their pre-tax monthly income or max out their monthly debt at 50% of their pre-tax monthly income. However, if you are concerned about budgeting, 29/41 is simply a good rule of thumb.
Here’s how to calculate these numbers:
Calculate Housing Expense Percentage:
To calculate the percent of your monthly income that currently goes toward your housing expense, divide your current mortgage/rent payment by your gross monthly income and multiply by 100. This will give you the percentage you spend each month. (Note: If you don’t know your gross monthly income, take your salary or the total amount of money make in a year before taxes are taken out, and divide by 12.)
Example: Susan currently spends $1800 on her mortgage each month. That $1800 includes the loan principle, interest, home insurance, property taxes, and condo fees. She makes $7000 a month (pre-tax/gross).
$1800 divided by $7000 = .25 x 100 = 25%. Right now, 25% of her gross monthly income goes toward her housing expense.
To calculate the maximum you should ideally pay toward a mortgage payment/housing expense, multiply your gross monthly income by .29 (the maximum most lenders like to see).
Susan’s example: $7000 x .29 = $2030. If she’s using the 29/41 rule as a conservative guide, Susan could afford to pay $2030 for her mortgage each month. This would include the principle, interest, insurance, and taxes.
Calculate DTI:
To calculate the percent of your pre-tax monthly income that goes toward paying off debt (your overall DTI), add up all your debt (ex: mortgage or rent, car loans, student loans, credit cards, child support, alimony, any other debt) and divide it by your gross monthly income and multiple by 100. You don’t need to include groceries, utilities, and other month to month expenses.
For example: Susan pays the following debt every month
$350 credit card minimum payment
$1800 mortgage
$450 car payment
$350 student loans
_________
$2950 (total debt) divided by $7000 (gross monthly income) = .42 x 100 = 42%
In Susan’s case, her current housing expense is 25% and her overall DTI is 42% of her gross monthly income.
Your DTI will influence the interest rate, amount of loan you can get, and potentially the down payment you need. The higher the DTI, the higher the risk you are to the lender because you have other debts to pay off which means you could default on your loan. They may charge more interest or limit the amount they will loan you to protect themselves.
Once you’ve estimated the mortgage you can afford to pay and your DTI, it’s time to consider other factors that will influence how much home you can afford to buy.
Interest Rates and Loan Term
Rates are determined by the lender. They can be fixed or adjustable (meaning they will go up and down) over the term of your loan. Your rate can be influenced by the market, your down payment, credit score, and other factors.
If Susan buys a $300,000 home with a 30-year fixed rate mortgage at 3.25% with a 10% down payment, her principal (the actual loan amount) and interest payment each month will be approximately $1,218.58 (principal and interest only). A 15-year fixed rate at 2.5% = $1867.01 (principal and interest only).
Neither of these examples include taxes, home insurance, or personal mortgage insurance. It’s more likely that Susan would pay closer to $1800 a month for a 30-year mortgage or $2400 for a 15-year mortgage.
The loan term you choose will depend on how quickly you want and are able to pay off your mortgage. A shorter loan term means higher monthly payments, but less interest paid over that period of time.
If you use a mortgage calculation tool online, keep in mind that they don’t always include property taxes, homeowner’s insurance, HOA or condo fees, or personal mortgage insurance (PMI) in their calculations. Some may use national averages, but the numbers won’t be exact. The best way to get an estimate is to start the loan application process which will tell you if you’re preapproved and for how much.
Down Payment
The down payment you make influences your monthly payment as well. You can get a conventional loan for as little as 3% down, however there are advantages to higher down payments:
Lower interest rates: The higher the down payment the less money the lender loans you which makes you less of a risk. Risk is a factor in when determining your interest rates.
No PMI: PMI is private mortgage insurance. It’s a monthly insurance fee for conventional loans that goes straight to the lender to protect them in case you default on the loan. When you place a down payment of 20% or more, you’re less of a risk to the lender and you won’t need PMI.
Cash Reserves
Some loan programs require anywhere from 2-6 months of mortgage payments in savings at the time of closing. The issue for lenders is risk. The issue for you to consider is this: Do I have the funds to cover your mortgage for a couple of months if I had a financial setback?
Determining how much house you can buy isn’t just a matter of the cash you have on hand to close the deal. It also means planning for the future and emergencies. Take the time to look at your other expenses and budget before starting the home buying process.
Additional Costs
As with any purchase, you need to be aware of the extra costs. We’ve mentioned that home insurance and property taxes can be attached to your monthly mortgage payments. You make a single monthly payment, and a portion goes toward paying off your loan and another portion goes to an escrow account that pays the homeowner’s insurance and taxes. Taxes and insurance will vary based on where you live and your insurance needs
Closing Costs: These are fees associated with the loan process (appraisals, title search, credit reports, origination, and other fees). They are paid at the time of the closing and usually range between 3-6% of the purchase price of the home.
Buying a home takes some planning, but it doesn’t have to be overwhelming. Start by having a good handle on your financial situation and learn how much cash it will take to buy a home. This will get you ready for the preapproval process and shopping for your new home. You can also use a mortgage calculator to estimate your monthly payment for various loan and down payment amounts.
