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Home Affordability 101: How Much House Can I Buy?

So you’re thinking about buying a home?

Congratulations! Homeownership still ranks as one of the top goals for most people (70%), just behind having a successful career (73%). However, taking on hundreds of thousands of dollars in debt for the next 30 years just to have your share of the American Dream is not something to be taken lightly.

Whether this is your first time or tenth time you’re about to purchase a home, one question we come back to is: How much house can I afford to buy? There are a lot of different ways to tackle this question and many valid points you should consider. Nonetheless, one thing is for sure – you should only take on homeownership when it makes good financial sense.

With that said, let’s dive into the topic of home affordability and see if there could be a “SOLD” sign in your new front yard soon by looking at:

home affordability and the 28/36 rule
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How Much Should You Spend on a House?

One of the first things you have to consider when it comes to buying a house is how much the mortgage payment will be. There are a lot of different variables that can ultimately determine how much your overall monthly payment will be. For example:

  • What’s the asking price (or the price you negotiate) for the house?
  • How much money do you have for a down payment?
  • What are the current mortgage interest rates?
  • Do you have a good credit history and a high FICO score?
  • Which type of mortgage will you apply for? Conventional, variable, FHA, etc.
  • How long does the mortgage term last? 30 years, 15 years, etc.
  • What are the mortgage closing costs that the lender will charge you?

Unfortunately, calculating the mortgage payment is just the beginning when it comes to owning a new home. Once you move in, there are a lot more things you’ll have to consider. For instance:

  • How much are the taxes and insurance? Taxes can vary widely from location to location.
  • Will you have to pay PMI (private mortgage insurance)? This is usually an additional fee when you don’t bring 20 percent for a down payment. (More on this below.)
  • Will the new home also require that you pay HOA (homeowners association) fees?
  • What will the utility bills be like (such as water or heating and cooling)?
  • How much is the annual maintenance (such as a large yard that needs mowed or a long driveway that needs snow removal)?
  • Will there be any renovations necessary, especially in the short-term?

Generally speaking, when you take in the complete picture of homeownership and how much it might actually cost you, it can become somewhat overwhelming at first. Be that as it may, there are some guidelines you can follow to help simplify the process.  

How Much a Bank Says You Can Afford – The 28-36 Rule

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One simple way to answer “how much house can I afford” is to consider how much a bank or mortgage lender is willing to approve you for. This something called the 28/36 rule and works as follows:

  • Rule of 28 – Your monthly mortgage payment should not exceed 28 percent of your gross monthly income. Sometimes also called the “mortgage income ratio”, this value will include both the principal and interest portion of your mortgage as well as any of the other required homeownership expenses such as the property taxes, homeowner’s insurance, and PMI. Example: If you earn $50,000 per year (before taxes), then your maximum payment should not exceed $1,400 per month. 
  • Rule of 36 – Your total debt payments should not exceed 36 percent of your gross monthly income. Also called the “debt to income ratio”, this value includes both your housing payment as well as any credit cards, auto loans, student loans, child support, etc. Example: If you earn $50,000 per year before taxes, then your overall debt should not exceed $1,800 per month. 

While these ratios can be very helpful and are widely used in the mortgage lending industry, remember that they are only just guidelines. In reality, a mortgage that constitutes 28 percent of your monthly income might be more than you can handle.

This is why your goal should never be to simply buy as much house as the 28-36 rule will allow. Intuitively, the lower your housing expenses are, the more money you’ll have for your other financial pursuits.

Using a Home Affordability Calculator

Another easy way to get an idea of how much house you can buy would be to try an online home affordability calculator. These are free all over the internet and will usually account for many of the variables we mentioned already. 

Keep in mind that while quick and helpful, all most of these calculators are doing is simply applying the 28/36 rule. To better understand how much you can afford, there’s one thing you need to do …  

Calculate How Much Your Budget Will Permit

Just like any new expense or loan, the best way to figure out how much home you can afford is to take a good, hard look at your finances and calculate the numbers for yourself.

Take a look at the last 6 to 12 months of your finances and ask yourself:

  • How much are you spending on rent or your current home now?
  • How much extra money could you afford to put towards a new home?
  • At what point would your finances become stressed?
  • If you lost your job, would you be able to make your payments for the next year?

Calculate how much money is actually going in versus going out every month, and then determine a number that you’d feel comfortable spending. If you’re married, talk all of this through with your spouse. Remember that if you truly need help, there are always impartial financial advisors who can provide their input too.   

Coming Up with a Mortgage Down Payment

Your down payment will have a huge impact on the size of your mortgage payments. The more money you can afford to pay upfront, the smaller the loan your lender will give you, and the less your monthly payments will be.

Classically, the industry norm is to put down at least 20 percent for a down payment. However, that figure has become somewhat relaxed over the years.

According to the National Association of Realtors, most U.S. homebuyers put down just 12 percent when they go to buy a house. As a matter of fact, most conventional loans will even allow as little as 3 percent for a down payment. Even the government’s FHA (Federal Housing Administration) loan only requires 3.5 percent.

PMI (Private Mortgage Insurance)

Not putting down at least 20 percent for a down payment more than likely means that your lender will require you to pay Private Mortgage Insurance. This is a special type of insurance that protects the lender in case you default on the mortgage. PMI varies in price but can easily add another $100 or so to your mortgage payment every month.

How to Save for a Down Payment

There’s no easy way around it. To build up a sizable down payment for a home purchase, it’s going to take some time and effort. The best place to start is to give yourself a full picture of your finances. We love Personal Capital’s platform for creating a platform for you to view your assets and liabilities and your expenses.

Beyond signing up with Personal Capital, here are a few tips on how you can save up for your down payment:

  • Strategically cut back on your unnecessary expenses.
  • Divert your raise every time your income increases.
  • Save your IRS refund or workplace bonus each year.
  • Take advantage of tax-saving opportunities like an FSA or HSA.
  • Take on side jobs and start hustling your skills! Even an extra $100 per month can make a difference. 

Another option you have is to borrow money from your IRA. The IRS will let you withdraw as much as $10,000 penalty-free for your first-time home purchase. You can actually double this to $20,000 if your spouse also has an IRA. However, you should proceed with caution since taking money out of your retirement funds will negatively impact its ability to achieve future growth for your retirement. 

The Impact of Mortgage Rates

As you may know, the demand to purchase a home (and refinance a mortgage) goes up materially as interest rates, and consequently, mortgage rates fall. To illustrate why that is the case, let’s consider a $300,000 house, with a $240,000 30-year fixed mortgage. 

At a mortgage rate of 4.75%, you will pay approximately $1,250/month and $210,000 in total interest. But, if mortgage rates drop to 3.75%, your monthly payment drops approximately $140, and the amount of interest you will owe over the life of the loan is $160,000, or $50,000 less!  

Interest RateMonthly PaymentTotal Interest
4.75%$1,250$210,000
3.75%$1,110$160,000
SAVINGS$140 / month$50,000

Let’s also consider the potential impact on housing prices. Let’s assume that you have done your budgeting and what you are comfortable with is a monthly payment of $1,250. If interest rates are at 4.75% then we can estimate that you will be able to afford a $300,000 house. This assumes 20% down, or $60,000, and a $240,000 mortgage. 

Now, let’s consider that interest rates drop to 3.75%. To maintain the $1,250/month, provided you can increase your down payment to $67,500, you can now afford a $337,500 house. So in theory, you could be looking at the exact same house, but a 1% drop in mortgage rate can increase the value of the house by 12.5%. 

Interest RateMonthly PaymentHome Price
4.75%$1,250$300,000
3.75%$1,250$337,500
1% Decrease12.5% Increase

How should you think about mortgage rates? 

When considering the examples above, you can think of mortgage rates as a factor before you own your home and a factor once you own your home. 

Before you own your home mortgage rates are going to be a driver of the value of houses. As mortgage rates go down, the collective market will be willing to pay more for a house. Conversely, if mortgage rates go up, the market will be less willing/able to pay for a house and prices will decrease.  

Once you own your home however, changing mortgage rates provide an opportunity for you to refinance your mortgage to save on the total interest like our first example. 

The Impact of Your Credit Score

If there’s ever been a time to put your credit score to work, its when you’re planning to buy a house! Generally speaking, the higher your FICO score (as close to 850 as possible), the better your interest rate will be. And that will save thousands of dollars for you over the long run.

For example, a difference in your FICO score of 100 points could cause a borrower to go from a rate of 4.0 to 4.5%. At those rates, a 30-year, fixed-rate loan of $240,000 (80% mortgage on a $300,000 house) would go from $1,164 per month to $1,216 per month. That’s an increase of $624 per year, and more than $18,000 over the life of the loan. 

Keep in mind that if your score is too low, you may not even qualify for the loan – period! According to Experian, you’ll need at least a FICO of 620 or better to be approved.

Tips For Improving Your Credit Score

With so much riding on your credit score, there are a few things you’ll want to do to help improve it:

  • Find out what your FICO score currently is. This can be done for free.
  • Download a copy of your credit report and review it for errors. Again, this can be done for free.
  • Pay your credit cards and loans on time. This shows lenders that you have a dependable track record.
  • Pay your credit cards off as much as possible. This will reduce your revolving balance.
  • Don’t close any legitimate accounts. This will increase the length of your credit history and show that you have more credit available.
  • Use your credit cards less. This will decrease your credit utilization ratio.
  • Don’t apply for any new credit cards or loans. Every time someone pulls your credit history, this will be a negative impact on your score and red flag to lenders.

Even if you don’t have any credit cards or loans and are currently renting, you could work with a service like that will use your rent payments to build your score. Building your credit history is a slow process, but it’s a move that definitely pays off in the end!

Should I Rent or Buy a House?

As bad as you might want to own a home, there could be many instances where it actually makes more sense to continue renting instead. For instance:

  • What is the average rental yield in your area? This looks at the average rental rate versus the average home price
  • Does your job require you to relocate to various locations every few months or years?
  • Do you change jobs within your industry frequently?
  • Do you travel frequently and not have time to maintain a home or yard?
  • Would you rather not deal with all of the hassles of homeownership?

Ultimately, this becomes a cost/benefit question. It is possible that in some cases renters could accumulate more wealth than homeowners if they invested the equivalent of a down payment plus the difference between a monthly home ownership expenses (mortgage, taxes, maintenance, etc) and rent in a diversified portfolio.

For you to know for sure, add up all your expenses associated with renting versus owning a home and compare them. If it costs you less to rent over buying a home, then just continue to do so.

But Aren’t I Building Equity When I Own a Home?

Yes, it is true that every time you make a mortgage payment, you’re building equity in your home. This means a portion of your payment is going directly towards you owning a higher percentage of the property as time goes on.

However, your equity may not even exist if the value of the house is decreasing. For several decades in the past, homeownership was looked at as a great investment because it was almost certain that you could sell your house for more than you paid for it. Yet, after the Housing Crash and Great Recession of 2008, many people got a rude awakening that home prices can’t go up forever.

In general, if you live in a great location with good neighbors, take care of the house, and the market conditions are good, then you can expect home values to rise. But if not, then your home may not be the investment you thought it was.

Keep in mind that when homes are purchased their price is heavily influenced by comparable house transactions (comps). If you are buying a house that is in-line, or fair value, relative to the comparable homes, then you will be dependent on the overall housing market improving. However, if you buy a house that is cheap relative to the comps and add value to your home, then you create more of an opportunity to build equity.

Smart Money Home Recommendation

If you’d like to buy a home, that’s great. But let’s do it in a way that’s smart and will put you in the best financial position possible.

To do this:

  • Don’t stretch yourself thin. Spend some time upfront putting together a budget and calculating what you can truly afford every month. Talk about it with your spouse and make sure you’re both comfortable with whatever you decide.
  • Unless you are buying a house with a lot of appreciation potential and you are going to renovate it, don’t buy a house until you’ve saved up a sizable down payment. Even though a lender may still approve you, it won’t be worth the higher mortgage payments and added PMI.
  • Boost your credit score. Your credit history is your ticket to qualifying for a mortgage and getting a solid rate. Spend some time making the right moves that will show the mortgage companies you’re exactly the kind of person they want to lend to.
  • Compare renting versus owning. You might actually be better off just continuing to pay rent.

Remember these points and you’ll be in good hands towards making your next home purchase. Happy house hunting!

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