Buying your first home is one of the biggest decisions you’ll make in your life. With so much riding on this purchase and the variety of emotions accompanying the home-buying process, it’s important to do simple, logical calculations before you start looking to ensure you’re not over-extending yourself or buying something you can’t afford.
Several home affordability calculators online will let you input a few details and give you a number. However, it’s important that you understand the relationship between your income and your mortgage and how they can influence what you buy.
In this article, we’ll crunch a few numbers and discuss factors to determine how much house you can afford and the pitfalls you’ll need to keep in mind.
How much can you afford in monthly mortgage payments?
To calculate how much house you can afford, you’ll first need to understand your income and monthly expenses to determine how much you can set aside for a monthly mortgage payment. You want to be comfortable with this number and even have a few months of mortgage loan payments in reserve in case of financial emergencies.
Once you know how much you can borrow, you can combine that with your down payment to get a better sense of the price range you can afford.
Here’s how to do this:
1. Add up your monthly income from all sources
This includes alimony, investment profits, and rental earnings. If you’re married or buying with a partner, you’ll want to add their income to the household income.
2. Add up all your expenses
This amount of money comes from your paycheck and adds up to your living costs. Err on the side of caution with these numbers and overestimate, if need be, because it’s far better to have money left at the end of the month than to realize you missed out on a few crucial expenses that will hinder your ability to pay the mortgage comfortably.
3. Add in homeownership costs
When renting, your landlord takes care of all the expenses involved with repairs and maintenance, but when you purchase a home, these costs will become your responsibility. Money spent on utilities, home maintenance, and upgrades should all be added to your monthly outgoings.
4. Factor in closing costs
While the down payment will be your biggest expense when purchasing the house, there will also be other small expenses that need to be considered when budgeting for this purchase. Closing costs are around 3-4% of the home price and include the following:
- Appraisal fees
- Home inspections
- Loan origination fees
- Credit reports
- Property taxes
- Homeowner’s insurance premiums
- HOA (Homeowner’s Association) fees
5. Run the numbers
Next, use a mortgage calculator or home affordability calculator to determine how much you can afford in monthly mortgage payments. Depending on your financial situation and goals, you’ll want to consider whether you want a 30-year mortgage or a shorter one.
The 28/36 Rule
A good rule of thumb for calculating how much home you can afford is the 28/36 rule, which stipulates that:
- You should spend no more than 28% of your gross monthly income on housing payments.
- Your total monthly debt payments shouldn’t exceed 36% of your gross or pre-tax income. This includes all debt payments, including mortgages, credit cards, car loans, and student loans.
To illustrate, let’s say you earn $5,000 a month. This would mean that your mortgage payment would be no more than $1,400, and your total debts wouldn’t exceed $1,800.
Your debt-to-income ratio
When you apply for a mortgage, lenders will consider your debt-to-income ratio (DTI). The DTI ratio compares a borrower’s total monthly debts to their pre-tax income to determine affordability and is used as a measure of risk.
To calculate your debt-to-income ratio, divide your total monthly debt by your gross monthly income and then multiply the resulting number by 100 to convert it into a percentage.
The higher the debt-to-income ratio, the riskier a homebuyer is to a bank or financial institution, and the more likely the mortgage lender is to doubt their ability to repay the home loan.
Many lenders will adhere to the 28/36 rule. If your DTI ratio is higher than the 28/36 rule, you’ll still be able to get a mortgage but may be charged higher mortgage interest rates and have to pay additional fees, such as mortgage insurance. This protects the lender if you cannot make your mortgage payments.
Factors that determine affordability
There are several important factors to consider when determining the affordability of a home purchase. These include:
Salaries, business income, dividends from investments, and alimony all count as income and will impact how much house you can afford. The higher your annual income, the more you’ll be able to borrow for a mortgage. Your income sets the baseline for money received each month. Experts such as Dave Ramsey recommend never spending more than 25% of your monthly take-home pay on mortgage payments.
Purchasing a house is not a simple matter of applying for a mortgage loan and buying the property. You’ll need a down payment and enough cash reserves to cover closing costs. You can, of course, use your savings or money from your investments to cover these costs. But if you’re on a budget and these non-negotiable costs are coming out of it, you’ll have less available as a down payment.
Debt and expenses
Outgoing expenses, whether in the form of debt or living expenses, are another important factor to consider when determining the affordability of a home. Your debt, which includes car payments, student loans, and credit card payments, will impact your debt-to-income ratio. This is a number lenders will consider before offering you a mortgage. And the more expenses you have, the lower your monthly mortgage payment needs to be.
Credit score and profile
Your credit history will largely determine how much you can borrow and at what rate. A high credit score and a history of paying bills on time will get you lower interest rates and more affordability. In contrast, a low credit score and a history of refinancing can result in you paying higher than the current mortgage rates and additional fees.
Mortgage loan term
Mortgage term is an important factor and one that you need to keep top of mind. Basically, it comes down to one question: How fast do you want to pay off your mortgage? The answer to this will come down to various aspects to do with your life and personality, such as how old you are when buying the property and how fast you’re moving ahead with your personal finance goals. Ultimately, though, a 30-year and 15-year mortgage will play out differently in your balance sheet and your monthly payments and is, therefore, an important aspect to consider.
Finally, how much you pay upfront for the home is important, too. While it’s common to put down 20% of the purchase price of a home, some loans will allow you to buy a property for as little as 3% down. However, the more you put towards the down payment, the more home equity you have.
Your mortgage options
The type of mortgage you apply for will determine how much you can borrow and the terms of repayment.
- Conventional loans: With a conventional loan, you’ll need to put down a 20% down payment. If you’re unable to do so, you can still take out a mortgage, but you’ll need to pay Private Mortgage Insurance (PMI) payments on top of the regular mortgage, which can cost anywhere from 0.5% to 1% of your loan amount per year.
- FHA loans: FHA loans are insured by the Federal Housing Administration, which means that the bank or financial institution will get paid even if you default on your payments. When qualifying for an FHA loan, you’ll need to prove that you intend to use the house as a primary residence and live in it within two months of closing.
- VA loans: The Department of Veterans Affairs backs these loans, and much like FHA loans, they’re more flexible in their terms. You don’t need a down payment with a VA loan, and eligible active duty or retired service members or their spouses can qualify.
- USDA loans: These loan types are backed by the U.S. Department of Agriculture and are designed to help finance homes in rural areas. A USDA loan is conditional on a property falling within a specific geographical area and must be a primary residence.
The bottom line
Buying a new home, especially as a first-time homebuyer, is a big decision that you must consider carefully after crunching the numbers. It’s important to understand how much you can afford so you can pay your monthly mortgage payments comfortably over the long term.
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