Although there are many translations of what the American dream means, one of the most common dreams for American's is to own a home. The idea of putting your mark on your own home and the investment opportunity make it very appealing for most people. Despite the economic downturn of 2007 – 2009, statistics show that the home ownership rate in America is on the rise. The United States seems to have rebounded from the slump in the housing market and things are booming.
Most homeowners in America can't pay for their house in cash. They need to take out a mortgage from a lender to make their dream a reality. Figuring out how to get a loan, your price range, etc. can be one of the most challenging financial journeys you will take.
One of the most common questions when taking the plunge into home ownership is how much house can I afford? We’ll help you determine the right fit for you and help you calculate the percent of your total income you can safely allocate to purchasing home. Below are 4 steps that you can use as a guide to answer the home affordability question.
Determining what home you should buy should be primarily driven by the following factors:
How much space you need
The type of home you want
Start off by taking stock of your current living situation. Do you have kids, if not will you someday? Do you need multiple bedrooms, if so how many? Answer these questions as best you can. You can always move, but getting the space question right will help you zone in on getting the right house for you.
Be really specific about how much room you actually need. Most people have many rooms in their house that they never use. Quite often, with a bit of planning, you can get away with a smaller house that should help with affordability.
Next is to think about neighborhood. Do you want to be in the city? Close to work? Is there a school that you prefer for your kids? Neighborhood is a much more complex question than it seems on the surface. Try to find 3-4 neighborhoods that hopefully have a range of prices within them. Also think about anything you might be willing to compromise on for neighborhood. Are you willing to live in a place that requires you to drive to work vs bike, but has great schools? All of these items should factor into your decision.
Then ask yourself the big question, “Based on my income, what type of house can I afford?" You don't have to answer this right now. We will get into the specifics in just a bit and hone in on a price range for the neighborhoods you selected in the previous step. Instead let it sit there and think about if any of the houses that you have selected seem affordable. Try to select a few from various price ranges that you can reference as we go through these steps.
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Now that you have a good idea of the kind of home that is right for you, explore your financing choices.
Do you have a large stash of cash to buy a home? Chances are that you don’t. People who purchased a home for cash accounted for less than 30% of home sales in Q3 of 2018. This means that you will need to get a mortgage. A mortgage requires you to put a down payment on the home as collateral for securing the mortgage. Most firms will require a minimum of 5% down payment, but some have loans for as little as 3% down.
If you think you will likely put 3-5% down, the government has put in place several programs to help you own a home. You can check your eligibility and work out how much loan you can afford including VA and FHA facilities. You sould read the fine print on these types of mortgages as some will require you to pay mortgage insurance (PMI) for the entire life of the loan.
As you are exploring your financing options lenders are going to pull your credit score. It is better to know what to expect for your credit score before going into the meeting. That way you aren't surprised and can have a rough idea of what possible interest rates they might offer you. If you need to check your credit score, we suggest credit karma and if you need to repair your score, we wrote an article detailing how to improve your score over time.
It’s hard to know how much you will need to pay as deposit before having a clear picture of what you can afford. Your debts and the down payment are the two most vital parts in determining how much house you can afford. Mortgage lenders are tasked with using your financial numbers to determine how much they are willing to lend you.
Lenders follow a rule known as the ability to pay rule. The rule compels mortgage lenders to make a reasonable attempt in determining if you can afford a mortgage. Lenders will assess your debt-to-income ratio, and how much you can pay up front.
The rule of thumb with regard to the debt-to-income ratio is: your average monthly debt repayments should not exceed 43% of your gross monthly income. Since most people likely have other loans, the portion remaining for mortgage repayments is much smaller than 43%.
Many mortgage lenders peg mortgage-to-income-ratio between 28% and 33%. However, conservative financial advisors, like Dave Ramsey put a more stringent figure of 25%.
A good rule of thumb is to keep your debt-to-income ratio as low as possible. We tend to agree on the more conservative side of keeping it below 25% if at all possible. In some more expensive locations, this might not be possible but try your best.
Lets run through a more concrete example. If you want to figure out roughly how much house you can afford based on your debt to income ratio your numbers might look something like this:
$5,000 monthly gross income ($60,000 salary)
$300 monthly student loan payment
$200 monthly car payment
Current debt to income ratio = $500 / $5,000 = 10%
Therefore you still have ~15-20% to work with. To see how much that is do the following:
$5,000 * .15 = $750
$5,000 * .2 = $1,000
This effectively means your mortgage payment should be somewhere in the range of $750 - $1,000 a month to still be considered affordable.
Your monthly mortgage installment is a significant determinant of how much house you can afford but there are other costs to consider. You should also factor in insurance costs, property taxes, Homeowners Association (HOA) fees where applicable, private mortgage insurance, furniture, décor and maintenance costs. These all add up and can considerably drive up your mortgage payment. HOA fees in particular can be very high in some locations so make sure to factor that in the numbers you are using for this step.
Now comes the fun part, seeing how much house you would be able to afford. The best place I like to start is to take a house you identified as a candidate and plugging the data into our mortgage payment calculator. See how much a 15 year and 30 year mortgage would cost for a house. If it fits within the range you calculated in the previous step, congratulations! If it doesn't, try adjusting the numbers lower until it fits in your budget.
The idea here is to determine how much you can afford while staying affordable. Quite often the number may be lower than you think. An inflated housing market lately has led to sky high prices, but don't let that deter you. Take your time and find a place that fits your needs, wants, and budget. You will thank yourself 5 years down the road that you didn't overbuy.