For many people, buying a home remains a major financial — and life — milestone.
The idea of owning your home might capture your imagination, but is it something you should do right now? You might be repaying student loans and trying to build an emergency fund. Maybe you even hope to start investing for your retirement.
Even with these other goals, it’s still possible to buy a home. However, you need to think about what it means for your pocketbook and your long-term lifestyle goals. A home purchase is a big deal, and your mortgage is a big commitment.
You need to answer the question “How much house can I afford?” and understand the impact your mortgage payments can have on the rest of your finances.
What I can afford vs. what they’ll lend me
When I began shopping around for mortgage rates back when I bought a home, I was shocked at how much house I “qualified” for.
As you start looking into pre-approval, you might discover that your mortgage lender insists that you can afford more than you thought. Your initial reaction is likely glee. After all, you can get a bigger house. Score!
Don’t get too excited about that number. There’s a difference between how much house you can afford according to a formula or mortgage calculator, and how much you can actually afford based on your individual financial situation.
Realize that a Qualified Mortgage requires that your debt-to-income (DTI) ratio be 43 percent or less.
In order to figure yours out, add up the minimum payments you make on all your loans, plus your potential mortgage payment. Then, divide this number by your gross monthly income (what you make before taxes and other deductions are taken from your paycheck).
If your gross monthly income is $4,000, your total debt payments can’t amount to more than $1,720 each month. If you have a $500 student loan payment, $300 car payment, and are paying a combined $200 in minimums on your credit cards, your total debt payments are $1,000.
This leaves $720 available for a mortgage payment.
You can get a mortgage for more than 43 percent DTI, but you will have to pay a much higher mortgage rate and it will be harder to find a lender that offers this product.
But does it really make sense to spring for the maximum you can borrow just because a lender approves you for something? It might not. Here are some things to consider when thinking about how much house you can afford.
Am I comfortable with the payment?
A house affordability calculator is often the first stop when trying to figure out mortgage size. Calculators can help you find a starting point, but should be used cautiously.
Some calculators just help you figure out what your payment (principal and interest) will be. Other calculators include estimates about what you might pay in property taxes and home insurance premiums.
When using a house affordability calculator, it’s important to take the results with a grain of salt. Just because a calculator says you can afford a payment doesn’t mean that it fits with your finances. Start with the calculator, then figure out how comfortable you will be with the payment.
Take a look at what you’re paying in rent. If you are stretching to make your rent payment, it makes sense to look for a payment that is less than you pay now. If you are comfortable with your current housing costs, you might have room for a higher mortgage payment.
Rules of thumb aren’t much better. You’ve probably heard of the 30 percent rule — it says you can spend up to 30 percent of your monthly income on your housing payment. But does this really make sense?
Many people base it on their gross income, even though that’s not actually what you bring home. If you use a rule of thumb, like 43 percent DTI or 30 percent of income, ditch the conventional wisdom and base it on your take-home pay.
Even better, do the math with your total housing expenses, including maintenance and repairs, utilities, taxes, and insurance. The amount you can “afford” will be smaller, but it will also give you more financial breathing room.
You should be comfortable with your payment and realistic about what you might have to give up to make it work. Take stock of your finances and decide if you can still cover your other obligations with your mortgage payment.
Don’t let someone talk you into getting a bigger house if you think you’ll be uncomfortable trying to make it work. The answer to “How much house can I afford?” starts with your comfort level.
Have I thought about the added costs of homeownership?
Home affordability isn’t just about your mortgage payment. You also have to think about additional costs related to owning a home.
You can use a house affordability calculator to estimate principal, interest, property taxes, and home insurance. These are your basic monthly costs. But how much house can you afford when you consider the following expenses?
- Increased utilities if you move into a larger dwelling: A bigger place means higher utility costs for heating and cooling, and even electricity and water.
- Maintenance: Whether you do it yourself or hire someone else, upkeep on a home costs money. Furnace tuneups, yard care, roof shingle replacements — figure maintenance items like these into your budget, because you probably haven’t had to pay for them as a renter.
- Repairs: When something breaks and you rent, the landlord fixes it. If the wind blows down your fence as a homeowner, you’re on the hook. Whether an appliance breaks or the carpet needs to be replaced, you pay the cost as the homeowner.
You can use the one percent rule to estimate your expected maintenance and repair costs. This general rule used by real estate investors is that yearly repair and maintenance costs are equal to about one percent of the property’s value.
If your home is worth $200,000, your annual maintenance and repair costs are likely to be $2,000. Divide that by 12 to get an approximate monthly cost of $167.
That doesn’t mean you will spend that much each month; home repairs don’t work like that. You can go months or years without issue, and then suddenly deal with a broken water heater, flooded basement, or leaky roof.
When figuring out how much house you can afford, add that extra monthly amount for maintenance and repairs to the estimated basic monthly costs of principal, interest, insurance, and taxes.
Would you be comfortable setting aside that much each month to help you cover maintenance and repair costs? If not, you might be getting more house than you can afford.
What are my long-term lifestyle expectations?
Don’t forget to factor in your long-term goals and lifestyle expectations. The other things you prioritize in your life impact how much home you can afford.
If you have a significant other, you probably think that you can afford a bigger house (and a bigger mortgage) because you have two incomes. But will you always be a two-income family?
If you have a goal to become a single-income family, what seems affordable now might not be affordable later. If you know one of you will stop working, it makes sense to base your calculations on one income to begin with.
What if you want to start a business later? Do you want to risk losing your home when your income becomes irregular? You might have to put off your plans for a business if you are stuck with a home that is more expensive than you can handle while trying to be an entrepreneur.
How much house can I afford?
You don’t want to end up house poor and unable to engage in other activities you enjoy. If you want to take regular family vacations, have money to go out to eat, or make sure you can set aside money for retirement, your mortgage might hold you back.
Look ahead to see whether or not the amount you pay on your mortgage will interfere with your other goals and priorities, from saving for your child’s college to building your emergency fund.
You can do multiple things with your spending plan, but make sure a massive mortgage payment isn’t dragging you down.