One of the top questions I hear from clients is, “How much house can I afford right now based on my salary?” Usually, they tell me what they make and want to know how much house they can afford based on that criteria. But salary is only one part of the equation.
To figure out how much house you can afford, take action on these five steps. You’ll be able to answer the question, what can I afford? And when you get approved for a mortgage, you’ll know you can keep your payments on track.
How much house can I afford? (Hint: Don’t let a mortgage lender decide.)
Mortgage lenders have all types of algorithms that help them determine risk. In stark terms, lenders apply your personal and financial information against their formulas to ultimately decide whether or not to approve your loan and for how much. In short, they are deciding whether or not you’re worth the risk. Of course, it becomes much more complicated when we look at how mortgages are insured and bought and sold (which impacts how mortgage lenders do business with homeowners). But is their answer the same as your answer?
The point is, you might not want your mortgage lender deciding what you can afford. Nevertheless, this is a common approach by a lot of homebuyers. The average homebuyer narrows down a location, attends open houses, then applies for the maximum amount they can afford on a home loan.
When all is said and done, you are the one who has to pay your mortgage for the life of the loan. Through thick and thin, career changes, health and family dynamics. The past year and a half put the unpredictable nature of our lives on notice. Despite how much a mortgage lender might be willing to lend you, take action to decide what you can afford on your own terms.
So then, how much house can you afford? Let’s break it down.
Step 1: Take a close look at your spending habits
First things first, take a close look at your spending habits and create a budget. Determine your income, different revenue streams, investments, or rental earnings. Next, list your expenses such as rent, utilities, groceries, health care, shopping and entertainment. Finally, look at your total debt. Include credit cards, loans, and student loan debt.
When you decide how much house you can afford, look at your current spending habits and your potential spending habits. How might things change when you buy a home? For example, you might need new budget items for home improvement, landscaping, or new furnishings.
Step 2: Follow the classic 28/36% rule
Financial advisors often recommend that individuals spend no more than 28% of their monthly income (before taxes) on housing expenses. This includes your rent/mortgage payment, utilities, homeowners insurance, and property taxes. For example, let’s say you make $7,000 per month. To calculate: multiply your monthly income by 28% (e.g., $7,000 x 0.28 = $1,960.)
Next, 36% is the maximum recommended amount of debt, including your house payment. This would include student loan debt, car loans, credit cards, personal loans. So in the example above this would mean $7,000 x 0.36 = $2,520. In this case, $2,520 would be the maximum affordability to cover your total debts, including your mortgage and housing costs.
Even if a lender is willing to approve a bigger loan with a higher payment, you have the ability to limit yourself and decide what’s affordable. The 28/36 is a tried and true basis for affordability.
Step 3: Analyze your debt-to-income (DTI) ratio
Your debt-to-income ratio compares your monthly income against your monthly debt payments. This number reveals whether or not you have flex room to take on more debt or if you’re maxed out. The higher your DTI, the more difficult it will be to get a mortgage. The lower your DTI, the more likely it is to get approved for a mortgage and a better rate.
Monthly expenses such as groceries, health insurance, or utilities are not included in your DTI ratio. Only debt obligations such as credit cards, car loans, or student loans. Some lenders will approve a mortgage up to 43-50% DTI for some loan programs.
Remember, you have the ability to choose your limits and decide to keep your mortgage affordable.
It’s a good idea to pay off as much debt as possible before you apply for a home loan. Keep some flex room between how much house you can afford and your final mortgage. This will give you some breathing room if your employment shifts.
Step 4: Boost your credit score
Find out your credit score and get a free copy of your credit report. It’s worth it to review your credit report and look for errors or misinformation. Most errors can be fixed and updated within 30 days. Next, pay down credit cards so that your credit lines aren’t hitting close to the limit.
When you have available credit, it also means you have options if financial difficulties arise. You’ll be in a better position if you stick with the 28/36 rule and have no more than 30% of your credit lines in use.
Step 5: Plan for your down payment
The bigger the down payment, the better the mortgage rate. When you provide a 20% down payment, the home immediately has 20% equity, so the mortgage lender is taking a smaller risk. This means your LTV (loan-to-value) ratio is 80%. The higher LTV means greater risk, which translates to less favorable terms on your mortgage.
When you decide to offer a large down payment, you will get a lower mortgage rate and a better mortgage overall with favorable terms. What’s more, if things change for you down the road, you’ll be to refinance your mortgage and modify your mortgage payment. When you have more than 20% equity in your home, you have more options to borrow, refinance, or cash out.
There are loan programs that require 0-5% as a down payment which you might qualify for, such as an FHA loan (requires 3.5% down). The conventional 97 requires a 3% down payment. The VA loan and USDA loan can qualify with zero down for eligible applicants.
Still, it’s your choice. By choosing to provide a larger down payment, you give yourself some breathing room if things change for you later.
If you’re wondering how much house you can afford, follow these tried and true action steps: track your spending habits, calculate your DTI, and follow the 28/36 rule. Mortgage lenders might qualify you for a loan amount higher than you want. It’s smart to create a financial plan that aligns with your long-term goals.
One caveat: mortgage rates remain historically low. Once they start to rise, you’ll be glad you’re locked into such a low rate! Low rates mean a lower mortgage payment. Right now, you can afford more house than you would if rates were higher. Take advantage of the low rates and start building equity right now. Follow the action steps and make a plan that works for your wallet.
As a mortgage broker, we partner with different mortgage lenders across California, Oregon, Washington, and Colorado. We can secure competitive quotes from multiple lenders to make sure you get the best mortgage possible at the rate you deserve. Give us a call to get started.