How much house can I afford? That is a question many home-buyers ask themselves when they are in the process of buying a new home. Purchasing a home is one of the most significant investments you will make. You must take the time to define a budget and carefully evaluate your financial situation before you start looking for your new home.
How much house you can afford depends on various factors, including your income, the size of your down payment, any existing outstanding debts, and your mortgage interest rate. Here are the five key factors you should consider when determining how much house you can afford. We will go into details for each further below.
- Down Payment – How much down payment do I need to buy a house?
- Mortgages – What are the various types of mortgage options?
- Lender Criteria – What numbers and ratios are critical to mortgage lenders?
- Closing Costs – What are closing costs, and how much money do I need for it?
- Property Taxes and Insurance – What is the impact of taxes and insurance on how much house I can afford?
1. How Much Down Payment Do I Need To Buy a House?
The first step in calculating how much house you can afford is determining the size of your down payment on the house. The required down payment amount will depend on various factors, including the terms your mortgage lender mandates, the type of mortgage loan you get, and how much money you have saved.
While many first-time home-buyers would like to think they can buy a home with no money down, this is rarely the case. To avoid paying for mortgage insurance, you must save up at least 20% of the house’s purchase price.
For example, let’s say you have $40,000 saved up for a down payment. Assuming a conventional mortgage at 20% down, you can aim for a home purchase price of $200,000 if your income and credit score support the mortgage of $160,000. Of course, other factors may bring that number down, such as closing costs and interest rates. We will get into those details further below.
2. What are the Various Types of Mortgage Options?
There are several types of mortgages, including 30-year fixed-rate loans, 15-year fixed-rate loans, and adjustable-rate mortgages, where the interest rate changes every 3 to 5 years. Talk to your lender about all your options.
The most popular type of mortgage is the conventional 30-year fixed-rate mortgage because it allows borrowers to have low monthly payments while still paying off their homes reasonably.
What If I Do Not Have a 20% Down Payment Saved?
If you don’t have enough saved up, options are still available.
- You can ask family or friends to help you or take out a loan against your existing assets. That will help you qualify for a conventional mortgage, a better long-term choice than the ones below.
- Alternately, ask your lender about FHA loans, federally insured mortgages with down payment requirements as low as 3.5%. FHA loans usually come with higher interest rates and mandatory mortgage insurance. These costs can add up over time. Therefore, we only recommend this option if your credit score is low or you cannot save up enough for a conventional mortgage.
- If you are a veteran or on active duty, you can qualify for a VA (Veteran Affairs) loan. This loan is similar to the FHA loan because it is federally insured, but VA loans usually require no down payment. At the same time, there is a funding fee of 2% to 4% of the loan amount. The mortgage interest rate is usually higher for a 15-year VA loan versus a 15-year conventional loan.
As you can see, various mortgage options allow you to put down little or no money upfront. Before you jump into it, ask your lender to calculate and provide a comparison of the total costs of choosing one option over the other. Most often, conventional mortgages with a 20% down payment will cost you less over the long term.
3. What Numbers and Ratios are Important to Mortgage Lenders?
Now that you have decided on your down payment and mortgage, the next step in calculating how much house you can afford is to figure out your debt-to-income ratio (DTI). This number is significant because it shows lenders the percentage of your income allocated to monthly debt repayment, including your mortgage payment.
Some home buyers get discouraged by their net worth, but it is essential to know that average net worth varies based on age and various factors. So while it is critical to understand how to calculate and compare your net worth against others for financial planning purposes, it is not critical for lenders.
Rule of 36%
A debt-to-income ratio greater than 36% is considered high-risk for lenders and may make it difficult for you to get the best interest rate.
Lenders want to ensure they’re not lending more money than you can afford to pay back, so they’ll look at your DTI and other factors, such as your credit score. So before you head to your bank, do a little math to calculate your DTI and ensure you will qualify for a loan.
Calculate Your Debt-to-Income Ratios
There are two ways to calculate your debt-to-income ratio: the front-end ratio and the back-end ratio.
- The front-end ratio is your monthly housing-related expenses divided by your gross monthly income. Do not include non-housing-related expenses in this one.
- The back-end ratio is the total of all your monthly debt obligations (including housing) divided by your gross monthly income.
Lenders typically prefer that you keep housing costs (front-end ratio) lower than 28% of your monthly income and your total expenses below 36%. So if you make $3,000 a month, they want your housing-related costs to be no higher than $840 and overall expenses no higher than $1,080 a month.
Another critical part of determining how much house you can afford is calculating how much monthly payment you can afford, which is based on the interest rate on your mortgage. Lenders usually provide a mortgage at lower interest rates for those with a high credit score.
Your credit score is determined by your ability to repay a loan on time, using information compiled from various sources, including public records and your history of paying back loans and credit card balances.
You can raise your credit score by paying all your bills on time and avoiding maxing out any payment cards. If you have a high balance relative to available credit, this will negatively impact your credit score. There are many other ways to raise or maintain your credit score. Click here to see a list of factors that may affect your score.
4. What Are Closing Costs and How Much Money Do I Need for Them?
In addition to your down payment, you will also need to pay closing costs. Closing costs are taxes and fees charged by the lender and other parties involved in the home purchase transaction, such as title companies, lawyers, and escrow agents. You may also have to pay appraisal fees and additional fees required by state law. A rule of thumb is to budget at least 1.5% to 2% of the purchase price for closing costs.
It’s also crucial to understand what portion of these costs are included in your loan or paid upfront because this affects how much money you will have available at closing time. For example, if your lender charges $3000 in closing costs and you’re required to pay $1000 upfront, you will only have $2000 available at closing.
5. What Is the Impact of Taxes and Insurance on How Much House I Can Afford?
The last step in calculating how much house you can afford is considering other factors such as property taxes and homeowners insurance rates in your area. These two costs can vary drastically from one city to another, so it’s essential to do your research before settling on a final number.
How To Get Ready: Budget and Get Your Credit in Order
After you have done the calculations above, it’s time to get ready by plugging any gaps in your savings, credit score, ratios, etc.
Start by creating a budget and getting your credit in order. Next, decide on an amount you can afford to spend each month and then create a budget that allows for this while also paying down your debts. If you don’t already have one, open a savings account or use an automated savings app so you can start saving money toward a down payment or emergency fund in case of unexpected expenses when buying a house.
Considering all these factors together will give you a reasonable estimate of how much house you can afford. If the number is too low for comfort, consider spending less on other expenses to help pay down your debts faster or take up some side hustles to increase your income so that you can finance more of your home purchase with cash instead of debt.
If you are still unsure about how much house you can afford, plenty of online calculators will do the math for you. Just enter all of your information accurately to get the most accurate number possible.
Buying a house is a considerable investment, so it’s essential to do your research and get the best deal possible. Follow the steps above, and you will be on your way to finding the perfect home for you and your family.
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This article originally appeared on Wealth of Geeks.
Ash & Pri
Ash & Pri are the founders of AshandPri.com, where they empower readers to make smart money decisions across all aspects of life. After achieving their FIRE goals in their 30s, they launched their blogging business in late 2021 and scaled it up quickly to generate a consistent income within a few months. You can find their expert financial advice & tips featured on sites like Forbes, GoBankingRates, Apartment Therapy, MSN, and more.