A common doubt of young adults dealing with purchasing their first home is if they can really afford it without having to pay bad financial consequences later. Whether you are a couple of spouses, a family, or a single individual you must consider that there are many expenses implied with housing, and buying your dream house without factoring in them is likely to turn out a mistake.
So, the straight answer to the question is: you can afford a house whose price will allow bearing the mortgage payments, housing costs and leave enough room in your budget for sustaining all the costs of living: pending debts you might have, bills, without forgetting “pleasure expenses” like dining out, vacations, cars and so on. A correct honest assessment should ideally be done before approaching a mortgage, in fact, lenders, including banks will tend to allow you pre-approval not considering expenses other than debts. You have to do your own math.
So, where do you start? The major determinant is, of course, your annual gross (before taxes) income, then you have to figure how much of it will be spent on the cost of the house. For this, there are formulas used by lenders to determine the maximum amount you can borrow: the 28/36 rule is the common standard for conventional mortgages, that applies to most of the prospective homeowners. This rule says that your mortgage payment (property taxes, fees, and homeowners insurance included) should be no more than 28% of your gross income, while your total debt ( mortgage plus other obligations toward loans payoff) should be no more than 36%.
For instance, if you earn $6,000 monthly, it would be safe to put a maximum of $1,680 for the mortgage payments on the table (the 28%); accounting for the remainder debts, you would reach $2,160 (the 36%) at most: credit card payments, student loans, car loans. This means that you will have $(6,000-2,160)=$3,840 available monthly to cover other recurring and non-recurring expenses. The 28/36 percent rule has recognized validity as it has been implemented over time, and to be intended as a guideline for decision making; it also acts as qualification criteria for conventional mortgage loans and is widely adopted all over North America.
While these numbers are used by most lenders, others might be less stringent with the intent to close the deals: that’s also why it is fundamental to quantify your budget.
In some cases, you may actually have the requirements to be approved with higher limits. Some lenders can allow 40% of your income to be spent on total debts: they can give you approval for the mortgage, but you have to be more careful about factoring other expenses: utilities, home maintenance, and repairs, tuition, funds for retirement, emergency fund, etc.
The above-mentioned percentages are known as debt-to-income (DTI) ratios: “back-end ratio” is the ratio of the total debt toward income, whereas the “front-end ratio” refers to the mortgage-to-income mathematic relationship. Some loans allow for higher DTI ratios: FHA mortgages usually apply the 31/43% rule (front-end ratio=31%; back-end ratio=43%). The back-end can reach 50%, even beyond in some exceptional cases. Be aware, though, that an FHA loan results to be costlier overall than a traditional mortgage.
Borrowers with better financial conditions (=higher credit scores) are justified to have slightly higher DTI ratios: you can manipulate your DTI basically reducing or paying off your debts before getting into a mortgage. This will ease your mind, and lastly lower your mortgage payments, making a house more affordable.
However, referring to your gross income is just a standard calculation: your take-home income is realistically the one you should take into account for determining the monthly payments that will be allocated for your home. If both you and your spouse earned $6,000, and in your State taxation is 22%, you would have actually $4,680 at your disposal to make the mortgage payments on top of other debts and recurring expenses: those $1,200 difference might be decisive about your comfort zone.
Besides income and total of debts, to determine affordability you have to consider the cash reserves available (savings, investments, other sources) to make a down payment of the mortgage: this is the main cost you will have to face in the short term, and its amount will influence your monthly mortgage installments. It would be ideal to put down at least 20% of the home purchase value, in order to avoid paying the further cost of private mortgage insurance (PMI): this is true for a conventional loan. A greater down payment improves home affordability, because lesser interests will be applied to the mortgage payments, so it’s worth taking the extra time to save for it.
One-time big lump sums, like closing costs, must be met: they can be between 2-6% of the home purchase value. If you want to buy a $200,000 house, assuming these costs are 3%, you will have to budget $6,000 upfront.
Choosing the lowest interest rate possible will also play a big role in home affordability in the long run: even a 0.5% lower interest will mean saving several tens of thousands of dollars in the span of 30, 15 years, or whatever your loan term. The rate will depend on the current market conditions, the lender of choice, and your financial status.
Once you have figured how much is your DTI, the amount of your down payment, and an interest based on actual rates (that will determine the total of mortgage payments: use our calculator), note every other necessary expense you are likely to face:
On top of your debt-to-income ratio, proof of steady income, and down payment amount, lenders will also watch that your cash reserves are enough to cover a certain number of mortgage installments. Most financial advisers recommend to have always at least 3 months of reserves, with 6 months desirable: you should come up with a fixed amount to save each month. That would be necessary to face eventual hard times, like losing job or unexpected big expenses. Be aware that your mortgage payments include: principal, interests, taxes, and home insurance. The total is what will be actually due.
Then, lenders will look at your credit history: they want to know how well you can and will deal with payments, which is clear proof of affordability. Your credit score is directly related to DTI and is obtained from credit institutions, based mainly on your income and transaction history. A higher score means essentially you are in a financial position to afford a pricier house and will get you a lower interest rate, which is crucial to managing the payments in the long term: it is definitely worth taking the time to improve your score, especially if it is less than good. You can check it at one of the major dedicated agencies: Experia, Equifax, or TransUnion.
Again, you are most likely to be approved for a bigger mortgage than you can actually afford: that would be the maximum you can borrow, without representing too much of a risk for lenders. Your home-buying budget should be ultimately established by yourself, because you may also want (and need) to set aside money for other things, such as financing college, retirement, an emergency fund, not to mention mundane expenses. It is best to look at monthly versus annual costs: comparing the total monthly mortgage payments with your monthly income, will let you know how much you have available for all the remaining expenses you may have. Write them down, and then you have home affordability.
Many future home buyers like to know how much house they can afford based on their salary. This refers to as home buying power.
Financial experts have inferred rules for answering this question:
These are just baselines, ballparks estimates (and ego calculations): an online tool plus pen and paper will make showing the real world numbers.
Let’s suppose you have a beautiful home in mind, but after all the calculations it resulted hard or impossible to afford either in the long or in the short term. You can always take some steps to improve your financial condition.
If you aren’t successful with these, you have still options:
Compare rates and conditions from different mortgage lenders, re-check your monthly payments, and see how much they fit in your income.