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Buying your first home is one of the most important and exciting financial events in your life. But before you head out on the street with a realtor, you need to have a good idea of a realistic budget..
You need to decide how much of a house you REALLY can afford. It’s not like the bank, hungry for your long-term interest payments, tells you that you can afford it.
Why accessibility matters
If you cannot pay cash for the house, you will rely on the mortgage lender to cover the costs. You will then need to make a payment to that lender over 15 or 30 years, depending on the term you choose.
More: 15 year mortgage vs. Mortgage for 30 years: how to choose
As with any loan, mortgage lenders try to reduce risk. You fill out an application and wait for approval, and this approval usually limits your loan to a certain amount. This limit is based on many factors.
But even if a lender says you’re approved for a $500,000 or $1 million home, that doesn’t mean you should go for it. You also need to look at what you can reasonably afford to pay each month.
This is where the three housing affordability rules can help.
Housing affordability rules
Mortgage lenders use so-called qualifying ratios to determine how much they will lend to a borrower. Although each lender uses slightly different ratios, most of them are in the same range.
Some lenders will provide a little more, some a little less. We took average qualification rates to derive three housing affordability rules.
Your maximum mortgage payment (Rule 28)
The golden rule in determining how much housing you can afford is that your monthly mortgage payment must not exceed 28% of your gross monthly income (your income before taxes).
For example, if you and your spouse have a combined annual income of $80,000, your mortgage payment must not exceed $1,866.
Your Maximum Total Housing Payment (Rule 32)
The next rule says that your total housing payments (including mortgage, homeowner’s insurance, and private mortgage insurance) [PMI]membership dues and property taxes) must not exceed 32% of your gross monthly income. This means that for the same couple, their total monthly housing payment cannot exceed $2,133 per month.
Your Maximum Monthly Debt Payments (Rule 40)
Finally, your total debt payments, including housing payments, car or student loan payments, and minimum credit card payments. must not exceed 40% of your gross monthly income.
In the example above, a couple with an income of $80,000 cannot have a total monthly debt payment that exceeds $2,667. If, say, they were paying $500 a month in other debt (such as car payments, credit cards, or student loans), their monthly mortgage payment would be capped at $2,167.
This rule means that if you have a large car payment or a large credit card debt, you will not be able to afford the same mortgage payments. In many cases, banks will not approve a mortgage until you have reduced or eliminated some or all of your other debts.
How to calculate a profitable mortgage
Now that you have an idea of how much a monthly mortgage payment you can afford, you’ll probably want to know how much home you can actually buy.
While you can’t determine an exact budget, until you know what interest rate you’ll be paying, you can estimate your budget.
Assuming an average interest rate of 6% on a 30-year fixed-rate mortgage, your mortgage payments will be about $650 for every $100,000 borrowed. (Just trust me on this – the math is hard).
For a couple making $80,000 a year, Rule 28 limits monthly mortgage payments to $1,866.
($1,866 / $650) x $100,000 = $290,000 (their maximum mortgage amount)
Ideally, you have a down payment of at least 10% and up to 20% of the purchase price of your future home. Add this amount to your maximum mortgage amount and you’ll have a good idea of the maximum amount you can spend on a home.
Note: If you make less than 20% down, your mortgage lender will require you to pay private mortgage insurance (PMI), which will increase your non-mortgage housing costs and reduce the amount of housing you can afford. Read all about PMI in our article here.
To better understand your individual payments, check out our mortgage calculator below:
Alternative types of credit
If the numbers above sound daunting, you can squeeze in some extra cash by taking out a loan that requires little to no down payment and offers a lower interest rate.
This will give you some wiggle room in the above ratios. If you or someone in your family is a veteran or active duty member of the military, consider a VA loan. Otherwise, an FHA loan may be the best choice for you.
FHA loan
For a conventional loan, the lender will require a 20% down payment to avoid PMI. Although the down payment is only 3%, it is only available to a select group of homebuyers. Chances are your down payment will be much higher.
That’s where an FHA loan can help. With FHA loans, down payment requirements are reduced to 3.5%., and claiming that lower rate is much easier than with a conventional loan. You can also qualify for a lower interest rate than a regular loan, which will cut that monthly payment down a bit.
But these benefits come at a price.
Relaxed eligibility requirements may slightly increase the cost of your mortgage insurance. With FHA loans, you will pay a mortgage insurance premium (MIP) both at closing and over the life of the loan. This premium cannot be removed after you pay off 20% of the loan, as is possible with conventional mortgages.
More: They are more affordable, but are FHA loans a good idea?
VA loan
Open to current and former military personnel only, VA loan allows you to skip the down payment altogether. You also won’t have to pay insurance for not depositing money. There is no mortgage insurance with VA loans.
With a VA loan, you simply pay the financing fee at closing. Currently, first-time VA loan borrowers pay 2.3%, rising to 3.6% if you have taken a VA loan before. You can skip this fee by paying at least 5% upfront.
The Veterans Affairs Administration does not require a credit score, but some lenders may require a score of 620 or higher before they can grant you a loan. VA lenders also typically look at your debt-to-income ratio and use applicants with a ratio of 42% or more at their discretion.
Other Factors to Consider
Debt and income is just one piece of the puzzle when it comes to what you can afford. Here are some other things that can affect the limit you set for yourself when you start looking for a new home.
Saving
Mortgage lenders like to look at your cash reserves when deciding whether to approve a loan. This shows the lender that if something happens to your income, you will have the funds to cover you within a month or two.
But the best thing about savings is that you can use some of it to fund your down payment. If you can afford 20%, you will cut your monthly expenses and possibly qualify for a lower interest rate.
Best of all, you won’t have to deal with private mortgage insurance, which will reduce your monthly mortgage payment.
More: What is the best way to save on a down payment on a house
Credit rating
Another thing that affects your mortgage interest rate is your credit score. Even if you’re going for an FHA or VA loan with a “very good” or “excellent” rating, lenders will see you as low risk.
What does it matter? Because the reduced interest rate saves you money every month. If you can get a 1% lower interest rate because of your large loan, you can save $100 a month or more. This lower payment means you can also afford a more expensive home.
Expected income in the future
House maybe investments. While it’s important to make sure you can afford the monthly payment, the truth is that your monthly mortgage today won’t seem that expensive in a few years if your income grows.
If you are just starting a new career, keep in mind future income as well. Although there are no guarantees, wages can rise quite quickly in some professions.
Maybe you are a programmer or cybersecurity professional who is currently gaining experience and certifications. Keep in mind that you are likely to make money in a couple of years, especially if you have extra savings to cover if you go bankrupt in the near future.
Where to get a mortgage
You have never had more options when it comes to getting a home loan. As always, there are large corporate lenders with local branches, local lenders and credit unions. But the internet has made things even more competitive by only offering online alternatives to conventional lending.
The best thing about all these options is that you can find competitive prices no matter your situation. You can also use sites that sell your credit to multiple lenders to help you find the best rate.
One of the places to start your search is – fiona. You don’t even have to fill out an application to see a long list of mortgage rates that apply to your desired loan amount, down payment percentage, term, purchase status, and credit score. This is a great way to get an idea of the current mortgage market.
Summary
The best way to determine how much home you can afford is to start with a budget. List your expenses, including what you currently pay for housing, and consider if now is not the best time to buy. You could benefit from waiting a couple of years while you work on saving for a down payment and improving your credit score. The better position you can get from the start, the more houses you can buy.
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Understand the basics? Use our resources to find a home you can afford:
