Buying a new home is a major investment. For many of us, it’s the most significant purchase we’ll ever make and impacts our lives for years to come.
It’s normal to want the most house for your money, but you don’t want to make a purchase that leaves you financially insecure. If you spend more on a house than you can afford, the slightest financial mishap can have disastrous consequences.
That’s why we’ve put together this guide to help you figure out how much you should spend on a house. We’ll cover the main factors determining how much house you can afford and then look at the different kinds of mortgage loans you might be eligible for. We’ll also answer a few of the most common questions people ask during the homebuying process.
Determining how much house you can afford
In an ideal world, you’d save enough money to buy your house with cash and live in a debt-free home. But in most cases, when you buy a home, you have to take out a mortgage from your bank, credit union, or other mortgage lender.
Many mortgage calculators available online that can help you determine what type of mortgage is best for you or the maximum mortgage interest rates you can afford.
Several factors influence the kind of mortgage you can get. Here are a few of the most important ones:
Your debt-to-income (DTI) ratio measures your total monthly debts against your monthly pre-tax income. Lenders often look at this number to gauge your financial situation and determine whether or not you’ll be able to make your monthly mortgage payments.
But qualifying for a mortgage doesn’t mean taking it is the best idea. You should always do your own calculations to determine what percentage of your household income you can comfortably spend on your mortgage.
The 36 percent rule
When looking at your DTI as a factor for your home purchase, many experts suggest following the 36 percent rule.
The rule suggests that your DTI shouldn’t exceed 36 percent to maintain a balanced monthly budget. That means your total monthly debt payments (including your mortgage and other housing expenses) should never add up to more than 36 percent of your gross monthly income.
For example, if you earn $6,000 a month, your total monthly debt payments shouldn’t exceed $2,160. If you already have $900 of monthly debt payments (from student loans, car loans, credit card debt, etc.), your monthly housing payments shouldn’t exceed $1,260.
Remember that housing payments include more than just your mortgage. How much you spend on housing should include closing costs, homeowners insurance premiums, and property taxes. Having a rainy day fund for any damages or accidents in your housing budget is always a good idea, too.
When applying for a mortgage, lenders perform a hard inquiry into your credit report. As with most loans, the higher your credit score, the bigger the mortgage you’re eligible to receive. You’ll also get lower interest rates on your monthly payments, which means less cost over the total duration of the loan.
The amount you can afford to put toward a down payment significantly impacts the mortgage you get. The more money you put down, the smaller the loan amount, resulting in lower monthly payments and a shorter loan term.
Make sure you consider all of your monthly expenses, like car payments or credit card payments, when evaluating what price range you’re shopping in.
Many people put 5 to 10 percent of their home’s price as a down payment. But if you can afford to pay 20 percent of your purchase price, you won’t have to pay for mortgage insurance, which saves you money on your monthly payments.
Loans have fixed or variable interest rates, and require down payments between 5 to 20 percent. If you put down less than 20 percent, you're required to buy private mortgage insurance.
Loans and how they affect the home you can afford
Mortgages come in many different shapes and sizes. Here are a few of the most common types:
Conventional loans usually have terms of 15 to 30 years. The longer the loan term, the smaller your monthly payments, but the higher the overall cost of the loan.
FHA loans are insured by the Federal Housing Administration and have more relaxed qualifying standards, making them ideal for first-time homebuyers.
For example, if you have a credit score higher than 500, your maximum DTI can be up to 43 percent without disqualifying you for the loan. If your credit score is over 580, your maximum DTI can go up to 50 percent.
However, FHA loans charge monthly mortgage insurance premiums, meaning less of your monthly payment goes toward paying off your principal debt.
If you have a military connection, you might be able to qualify for a VA loan. VA loans are backed by the Department of Veterans Affairs. They typically don’t require a down payment and are more lenient than conventional or FHA loans.
With a VA loan, you’ll receive a higher allowable DTI and don’t have to pay for mortgage insurance, but you will have to pay a funding fee.
FAQs about saving for a house
How much house can I afford based on my salary?
To calculate how much house you can afford, use the 36 percent rule. Never spend more than 36 percent of your monthly take-home pay (after tax) on debt payments, including your monthly mortgage.
The 36 percent limit includes student loans, car loans, credit cards, lines of credit, and personal loans. You should consider principal, interest, property taxes, home insurance, private mortgage insurance (PMI), and homeowners association (HOA) fees when calculating housing payments. Don’t forget to include your mortgage monthly rate.
How much down payment do I need?
The ideal amount of money for a down payment is 20 percent of the home value. This amount saves you the expense of paying for mortgage insurance because it buys you equity in the home, which helps secure the loan.
While VA loans or other 0 percent down payment programs allow you to qualify for a mortgage with little or no down payment, you should plan to put at least 5 to 10 percent of the home’s value as a down payment for a head start.
What can I do if I want more home than I can afford?
If you have your sights set on a home that costs more than you can afford or would force you to break the 36 percent rule, the first steps you should take are paying off your debt and increasing your annual income. These steps will help lower your DTI ratio, giving you access to a bigger mortgage and a more expensive house.
You can also improve your credit score by paying bills on time and keeping your credit utilization low.
The bottom line
It can be easy to get carried away with the excitement of buying real estate.
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