Knowing you want to buy a home is one thing, but do you know how much house you can afford? How do you pinpoint a house where the monthly mortgage payment is financially within your reach, and one that won’t drive you deep into debt? Let’s take a look…
Your mortgage payment depends on your income
Understanding and getting a ballpark estimate of how much house you can afford begins with looking at your income. The general rule of thumb is that you can purchase a home that costs two or three times your annual income.
So, if you earn $80,000 per year (and you have a reasonable amount of job security and don’t expect wild fluctuations in your income anytime soon), you can afford a house up to three times that, or $240,000. Keep in mind that income isn’t everything, and this is just an estimate to get you started because it doesn’t account for your monthly bills. Let’s get more specific…
Your mortgage payment also depends on your debt
Your income is only half the picture of what determines the monthly mortgage payment you can afford. The other half is your debt. This means the debt you owe to credit cards, college loans, and other credit sources. Even if your income is high, having high credit debt means you have less money to put toward a monthly mortgage.
One way to factor your income and credit debt into how much mortgage you can afford is to follow the 28/36 rule, a simple but effective ratio for mortgage affordability.
The “28″ refers to your monthly housing payment—things such as mortgage, home insurance, and property taxes—which shouldn’t be more than 28% of your gross monthly income (ideally this payment should be less). This payment is easy to calculate, because all you need to do is multiply. For example, if your gross (meaning before taxes are taken out) monthly income is $6,000, you would multiply that by 28% (or 0.28), which equals $1,680—this is the maximum amount of your monthly housing payment.
The “36″ refers to your debt-to-income ratio. This ratio compares your debt, or how much money you owe (to credit cards, colleges, car loans, and—hopefully soon—a home loan) to your income. This ratio should be “no more than 36%,” says Freeman; ideally, this ratio should be much lower.
Think about this ratio in terms of your monthly expenses: If you have a monthly income of $6,000 but also spend $500 paying off credit cards or other debt, you would divide $500 by $6,000 to get a debt-to-income ratio of 8.3%. This ratio is great but adding $1,680 in monthly mortgage payments would push up your debt load to $2,180 and your debt-to-income ratio to 36%. This ratio is exactly the maximum experts say you can afford. Going past this threshold is a risky move. You really shouldn’t ignore this ratio, because you could end up with a house that, over time, could drive you even deeper into debt.
Your mortgage payment depends on your down payment
And last but certainly not least, the amount you have for a down payment matters, too. To get the best mortgage rates and terms, you ideally want a down payment that amounts to 20% of the price of the house. But if you’re like most people, you don’t have that much. Understand, you can put down less. FHA loans, for instance, need a down payment of only 3.5%.
Now that you know your down payment plan as well as your income and debt ratio, it’s pretty easy to work out the maximum monthly mortgage payment you can afford which also helps you purchase the right home at the right price.
For example: if you earn $6,000 monthly, pay $500 monthly in debts (pre-house), and can make a down payment of $40,000, if you get a 30-year fixed mortgage at 4% interest you can afford a house worth $277,800.
You should always get a mortgage pre-approval
Contact a mortgage lender and apply for a mortgage pre-approval to get a sense of how much you can comfortably pay in monthly mortgage payments. This is where the lender looks at your income, debt, credit score, credit report, and other factors of your financial past to determine how much money they are willing to loan you to buy a home.
If you’re unsure what your credit score is and why it matters, you can read more about it in our blog post Understanding Your Credit Score. The better your score, the better your odds are of landing a great mortgage. You can also check your credit score for free at CreditKarma.com.
If your payment to debt sources has had some rough patches via late or missing payments, this could stand against you. The good news? If you take care of past debt and make your monthly payments on time, you can improve your credit score over time.
Not only does mortgage pre-approval tell you exactly how big your monthly mortgage payment can be, it also makes you a more attractive buyer, since they know you have financing to back up your offer.
Add it all together = How much house you can afford! Now you can confidently embark on your house hunt!