How Much Home Can I Afford?

How Much Home Can I Afford?

When determining what home price you can afford, a guideline that’s useful to follow is the 36% rule. Your total monthly debt payments (student loans, credit card, car note and more), as well as your projected mortgage, homeowners insurance and property taxes, should never add up to more than 36% of your gross income (i.e. your pre-tax income).

While buying a new home is exciting, it should also provide you with a sense of stability and financial security. You don’t want to find yourself living month to month with barely enough income to meet all your obligations: mortgage payments, utilities, groceries, debt payments – you name it.

In order to avoid the scenario of buying a house you truly can’t afford, you’ll need to figure out a housing budget that makes sense for you.

The table above used $600 as a benchmark for monthly debt payments, based on average $400 car payment and $200 in student loan or credit payments. The mortgage section assumes a 20% down payment on the home value. The payment reflects a 30-year fixed-rate mortgage for a home located in Kansas City, Missouri. Plug your specific numbers into the calculator above to find your results. Since interest rates vary over time, you may see different results.

In practice that means that for every pre-tax dollar you earn each month, you should dedicate no more than 36 cents to paying off your mortgage, student loans, credit card debt and so on. (Side note: Since property tax and insurance payments are required to keep your house in good standing, those are both considered debt payments in this context.) This percentage also known as your debt-to-income ratio, or DTI. You can find yours by dividing your total monthly debt by your monthly pre-tax income.

Most banks don’t like to make loans to borrowers with higher than a 43% debt-to-income ratio. Although it’s possible to find lenders willing to do so (but often at higher interest rates), the thinking behind the rule is instructive.

If you are spending 40% or more of your pre-tax income on pre-existing obligations, a relatively minor shift in your income or expenses could wreak havoc on your budget.

Banks don’t like to lend to borrowers who have a low margin of error. That’s why your pre-existing debt will affect how much home you qualify for when it comes to securing a mortgage.

But it isn’t only in your lender’s interest to keep this rule in mind when looking for a house - it’s in yours too. Since lenders tend to charge higher interest rates to borrowers who break the 36% rule, you’ll probably end up spending more on interest if you go for a house that places you beyond that limit. Plus, you may have trouble maintaining your other financial obligations, including building up your emergency fund and saving for retirement.

A financial advisor can aid you in planning for the purchase of a home. To find a financial advisor who serves your area, try SmartAsset's free online matching tool.

How Much Down Payment Do I Need?

Another key number in answering the question of how much home you can afford is your down payment.

The rule of thumb still stands: 20% of the home value is the ideal amount of money for a down payment. This amount buys you equity in the home, which helps secure the loan. When you don’t have a least 20% to put down, you have to find alternate means to secure the mortgage.

This can mean private mortgage insurance (PMI), which is an added monthly charge to secure your loan. If you don’t have enough money for a down payment, many lenders will require that you have mortgage insurance. You’ll have to pay your monthly mortgage as well as a monthly insurance payment, so it’s not the best option if your budget is tight.

You’ll stop paying PMI when your mortgage reaches about 78% of the home’s value. While certain homebuyers can qualify for little or no down payment, through VA loans or other 0% down payment programs, most homeowners who don’t have a large enough down payment will have to pay the extra expense for PMI.

How Much Should I Have Saved When Buying a Home?

Lenders generally want to know you will have a cash reserve remaining after you’ve purchased your home and moved in, so you don’t want to empty your savings account on a down payment.

Having some money in the bank after you buy is a great way to help ensure that you’re not in danger of default and foreclosure. It’s the buffer that shows mortgage lenders you can cover upcoming mortgage payments even if your financial situation changes.

While maintaining a debt-to-income ratio under 36% protects you from minor changes in your finances, a cash reserve protects against major ones.

At a minimum, it’s a good idea to be able to make three months’ worth of housing payments out of your reserve, but something like six months would be even better. That way, if you experience a loss of income and need to find a new job, or if you decide to sell your house, you have plenty of time to do so without missing any payments.

The table above is for a $250,000 home in Kansas City, Missouri. The mortgage payments assume a 20% down payment, and they include property taxes and home insurance.

Think of your cash reserve as the braking distance you leave yourself on the highway - if there’s an accident up ahead, you want to have enough time to slow down, get off to the side or otherwise avoid disaster.

Your reserve could cover your mortgage payments - plus insurance and property tax - if you or your partner are laid off from a job. It gives you wiggle room in case of an emergency, which is always helpful. You don’t want to wipe out your entire savings to buy a house. Homeownership comes with unexpected events and costs (roof repair, basement flooding, you name it!), so keeping some cash on hand will help keep you out of trouble.

What Home Can I Buy With My Income?

A quick recap of the guidelines that we outlined to help you figure out how much house you can afford:

• The first is the 36% debt-to-income rule: Your total debt payments, including your housing payment, should never be more than 36% of your income.
• The second is your down payment and cash reserves: You should aim for a 20% down payment and always try to keep at least three months’ worth of payments in the bank in case of an emergency.

Let's take a look at a few hypothetical homebuyers and houses to see who can afford what.

House #1 is a 1930s-era three-bedroom ranch in Ann Arbor, Michigan. This 831 square-foot home has a wonderful backyard and includes a two-car garage. The house is a deal at a listing price of just $135,000. So who can afford this house?

Analysis: All three of our homebuyers can afford this one. For Teresa and Martin, who can both afford a 20% down payment (and then some), the monthly payment will be around $800, well within their respective budgets. Paul and Grace can afford to make a down payment of $7,000, just over 5% of the home value, which means they’ll need a mortgage of about $128,000. In Ann Arbor, their mortgage, tax and insurance payments will be around $950 dollars a month. Combined with their debt payments, that adds up to $1,200 – or around 34% of their income.

House #2 is a 2,100-square-foot home in San Jose, California. Built in 1941, it sits on a 10,000-square-foot lot, and has three bedrooms and two bathrooms. It’s listed for $820,000, but could probably be bought for $815,000. So who can afford this house?

Analysis: While this one’s a little outside of our other homebuyers’ price range, Martin can make it happen. Using the 36% rule, Martin’s monthly housing budget is around $14,000. The mortgage, property tax and insurance on this property will total somewhere around $4,100 – so he could actually afford to pay more on a monthly basis. For a house this expensive, lenders require a larger down payment – 20% of the home value – so Martin is limited to a house worth five times his savings (minus that cash reserve equaling three months’ payments).

House #3 is a two-story brick cottage in Houston, Texas. With four bedrooms and three baths, this 3,000-square-foot home costs $300,000. So who can afford this house?

Analysis: Martin can easily afford this place, while it is a bit harder for Teresa. Assuming she makes a down payment of $27,300, or just under 10%, her monthly housing payments will be $2,110. Add in the $500 student loan payments she’s making each month, and you’ve got total debt payments of $2,610, which is exactly 36% of her income. Plus, even after she pays her down payment and all the closing costs, she’ll have around $7,800 left in savings, enough for four months’ worth of housing payments.

How Much Mortgage Can I Afford?

Even though Martin can technically afford House #2 and Teresa can technically afford House #3, both of them may decide not to. If Martin waits another year to buy, he can use some of his high income to save for a larger down payment. Teresa may want to find a slightly cheaper home so she’s not right at that maximum of paying 36% of her pre-tax income toward debt.

The problem is that some people believe the answer to “How much house can I afford with my salary?” is the same as the answer to “What size mortgage do I qualify for?” What a bank (or other lender) is willing to lend you is definitely important to know as you begin house hunting. But ultimately, you have to live with that decision. You have to make the mortgage payments each month and live on the remainder of your income.

So that means you’ve got to take a look at your finances. The factors you should be looking at when considering taking out a mortgage include:

• Income
• Credit score
• Existing debt
• Down payment and savings
• Mortgage term
• Current interest rates
• Private mortgage insurance
• Local real estate market

Plugging all of these relevant numbers into a home affordability calculator (like the one above) can help you determine the answer to how much home you can reasonably afford.

But beyond that you’ve got to think about your lifestyle, such as how much money you have leftover for travel, retirement, other financial goals, etc. You might find that you don’t want to buy the most expensive home that fits in your budget.

Why You Should Consider Buying Below Your Budget

There is something to be said for the idea of not maxing out your credit possibilities. If you look at houses that are priced somewhere below your maximum, you leave yourself some options. For one, you will have room to bid if you end up competing with another buyer for the house. As an alternative, you’ll have money for renovations and upgrades. A little work can transform a home into your dream house — without breaking the bank.

Perhaps more importantly, however, you avoid putting yourself at the limits of your financial resources if you choose a house with a price lower than your maximum.

You will have an easier time making your payments, or (better yet!) you will be able to pay extra on the principal and save yourself money by paying off your mortgage early.

Why You May Want to Wait to Buy a Home

Along the same lines of thinking, you might consider holding off on buying the house.

The bigger the down payment you can bring to the table, the smaller the loan you will have to pay interest on. In the long run, the largest portion of the price you pay for a house is typically the interest on the loan.

In the case of a 30-year mortgage (depending, of course, on the interest rate) the loan’s interest can add up to three or four times the listed price of the house (yes, you read that right!). For the first 10 years of a 30-year mortgage, you could be paying almost solely on the interest and hardly making a dent in the principal on your loan.

That’s why it can make a significant difference if you make even small extra payments toward the principal, or start with a bigger down payment (which of course translates into a smaller loan).

If you can afford a 15-year mortgage rather than a 30-year mortgage, your monthly payments will be higher, but your overall cost will be drastically lower because you won’t be paying nearly so much interest.

The table above shows a comparison of 30-year vs. 15-year fixed-rate loans for a $250,000 home with a 20% down payment. The monthly payments for the $200,000 mortgage includes homeowners insurance and property taxes for Kansas City, Missouri.

That sounds great, but it’s not always the best option either. If the 15-year mortgage puts you uncomfortably close to your maximum — meaning you won’t have any room in your budget for emergencies or extras — you could always lock into a 30-year mortgage while making a commitment to yourself to make payments the size of the 15-year plan unless there’s a financial emergency.

If you go with this plan it’s important to make sure your mortgage terms don’t include a penalty for paying off the loan early. This is known as a pre-payment penalty and lenders are required to disclose it.

So Should I Buy a Home?

The answer to that question depends on your financial status and your goals. Just because a lender is willing to give you money for a home doesn’t necessarily mean that you have to jump into homeownership. It’s a big responsibility that ties up a large amount of money for years.

It’s important to remember that the mortgage lender is only telling you that you can buy a house, not that you should. Only you can decide whether you should make that purchase.

Next Steps

Read more on specialized loans, such as VA loan requirements and FHA loan qualification. In addition, take a look at the best places to get a mortgage in the U.S. You can also check out current mortgage rates in your area for an idea of what the market looks like.

Tips to Improve Your DTI Ratio

If you want to buy a home but you are carrying too much debt to qualify for a mortgage, you may first want to focus on improving your debt-to-income ratio. There aren’t any tricks to decreasing your DTI. You have three main avenues to improve your DTI:

• Consolidate debt
• Pay off debt
• Increase income

If credit card debt is holding you back from getting to 36%, you might want to consider a balance transfer. You can transfer your credit card balance(s) to a credit card with a temporary 0% APR and pay down your debt before the offer expires.

This means your money is going toward your actual debt and not interest on that debt. It’s important to remember that if you don’t manage to pay down the debt before the 0% APR offer ends, you might end up with a higher interest rate on your debt than you had before.

But if you can swing a balance transfer it might be able to help you fast-track your debt payment and get you to the debt-to-income ratio you need to qualify for a home purchase.

Your other two options, pay off debt and increase income, take time. Perhaps you need to make a budget and a plan to knock out some of your large student or car loans before you apply for a mortgage. Or you wait until you get a raise at work or change jobs to apply for a mortgage.

There isn’t an easy way to a lower DTI, unfortunately. All three options take time, as well as planning to execute. But, think of it this way, you’ll improve your chances for a favorable mortgage, which is usually 30 years of your life. Waiting a few years to put yourself in a better position is just a fraction of time compared to the many years you’ll spend paying your monthly mortgage bill.