Buying your first home is one of the most important and exciting financial milestones of your life. But before you hit the streets with a realtor, you should have a good sense of a realistic budget.
You need to figure out how much house you can afford. Not how much a bank, hungry for your long-time interest payments, tells you that you can afford.
Today, we’ll show you how to shop for a home, the smart way.
Why affordability matters
Unless you can pay cash for a house, you’ll rely on a mortgage lender to cover the expense. You’ll then have to pay that lender for 15 or 30 years, depending on the terms you choose.
But even if a lender says you’re approved for a $500,000 or $1 million house, that doesn’t mean you should go for it. You also need to look at what you can reasonably afford to pay each month.
That’s where the three rules of home affordability can help out.
The 3 rules of home affordability
Mortgage lenders use something called qualification ratios to determine how much they will lend to a borrower. Although each lender uses slightly different ratios, most are within the same range.
We have taken average qualification ratios to develop our three rules of affordability.
Your maximum mortgage payment (Rule of 28)
The golden rule in determining how much home you can afford is that your monthly mortgage payment should not exceed 28% of your gross monthly income (aka your income before taxes are taken out).
For example, if you and your spouse have a combined annual income of $80,000, your monthly mortgage payment should not exceed $1,866.
Your maximum total housing payment (Rule of 32)
The following rule stipulates that your total housing costs (including the mortgage, homeowners insurance, private mortgage insurance or PMI, association fees, and property taxes) should not exceed 32% of your gross monthly income. So, if the couple mentioned above were to purchase a home, their total cannot be more than $2,133 per month.
Your maximum monthly debt payments (Rule of 40)
Finally, your total debt payments, including your housing, auto, or student loan, and credit cards, should not exceed 40% of your gross monthly income.
In the above example, the couple with an $80k income could not have total monthly debt payments exceeding $2,667. If, say, they paid $500 per month in other debt (e.g., car payments, credit cards, or student loans), their monthly mortgage payment would be capped at $2,167.
This rule means that if you have a big car payment or a lot of credit card debt, you won’t be able to afford as much in mortgage payments. In many cases, banks won’t approve a mortgage until you reduce or eliminate some or all other debt.
How to calculate an affordable mortgage
Although you cannot determine an exact budget until you know what mortgage rate you will get, you can still estimate your budget.
Assuming an average 6% interest rate on a 30-year fixed-rate mortgage, your mortgage payments will be about $650 for every $100,000 borrowed. (Trust me on that — the math is complicated).
For the couple making $80,000 per year, the Rule of 28 limits their monthly mortgage payments to $1,866.
($1,866 / $650) x $100,000 = $290,000 (their maximum mortgage amount)
Ideally, you have a down payment of at least 10%, and up to 20%, of your future home’s purchase price. Add that amount to your maximum mortgage amount, and you have a good idea of the most you can spend on a home.
Note: if you put less than 20% down, your mortgage lender will require you to pay private mortgage insurance (PMI), which will increase your non-mortgage housing expenses and decrease how much house you can afford. Read all about PMI in our article here.
To get a better sense of your payments, try our mortgage payment calculator.
Alternative loan types
If the above numbers seem daunting, you can squeeze out a little extra money by taking out a home loan that requires little to no down payment and offers a lower interest rate.
This will give you some wiggle room in the above ratios. If you or someone in your household is a veteran or current military service member, consider a VA loan. Otherwise, an FHA loan might be the best choice for you.
For a conventional loan, a lender will require a 20% down payment to avoid PMI. Although down payments are as low as 3%, this is available only to a select group of homebuyers. Chances are, your down payment will be much higher.
That’s where an FHA loan can help. With FHA loans, down payment requirements go as low as 3.5%, and it’s much easier to qualify for that lower rate than with a conventional loan. You may also be eligible for a lower interest rate than you would with a conventional loan, which will cut that monthly payment a little.
But these benefits do come with a price.
The relaxed qualification requirements can push your mortgage insurance up a little. With FHA loans, you’ll pay the mortgage insurance premium (MIP) both at closing and throughout the life of the loan. That premium can’t be removed once you’ve paid down 20% of the loan, as it can with conventional mortgages.
Open only to current and former military service members, a VA loan lets you skip the down payment altogether. You won’t have to pay insurance for not putting money down, either. There’s no mortgage insurance with VA loans.
With a VA loan, you’ll just pay a funding fee at closing. Currently, first-time VA loan borrowers pay 2.3%, increasing to 3.6% if you’ve taken a VA loan before. You can skip this fee by putting at least 5% down.
The Veterans Administration has no credit score requirement, but some lenders may require a score of 620 or better before issuing you the loan. VA lenders will also typically look at your debt-to-income ratio and use their own discretion for applicants with a ratio of 42% or more.
Other factors to consider
Debt payments and income are just one piece of the puzzle regarding what you can afford. Here are some other things that could affect the limit you set for yourself when you start searching for a new home.
Mortgage lenders like to look at your cash reserves when deciding whether to approve you for a loan. This shows a lender that you’ll have funds to cover you for a month or two if something happens to your income.
But the best thing about savings is that you can use some of it to fund your down payment. If you can afford 20%, you’ll cut your monthly cost and possibly qualify for a lower interest rate.
Best of all, you won’t have to deal with private mortgage insurance, which will reduce your monthly mortgage payment.
Another thing that impacts your mortgage interest rate is your credit score. Even if you’re going for an FHA or VA loan, having a very good or excellent score will have lenders seeing you as low risk.
How does this matter? Because a reduced interest rate saves you money each month. If you can get an interest rate 1% lower because of your solid credit, you could save 0 a month or more. This lower payment means you can also afford a more expensive house.
Expected future earnings
A home can be an investment but the truth is most times your house isn’t an investment. While it’s essential to make sure you can afford your monthly payment, the truth is, your monthly mortgage today won’t seem as expensive in a few years, assuming your income increases.
If you’re just starting a new career, keep future earnings in mind. While there are no guarantees, some jobs have salaries that can escalate pretty quickly.
Maybe you’re a computer programmer or cybersecurity specialist currently getting experience and certifications. Keep in mind what you’re likely to be making in a couple of years, especially if you have extra savings to cover you if you come up short in the near term.
Where to get a mortgage
You’ve never had more options for getting a loan to buy a home. As always, there are big corporate lenders with local branches, local lenders, and credit unions. But the internet has made things even more competitive, offering online-only alternatives to brick-and-mortar lending.
The best thing about all these options is that you can find competitive rates, regardless of your situation.
The best way to determine how much home you can afford is to start with a budget. List your expenses, including what you’re currently paying for housing, and consider whether now’s the best time to buy. You could benefit from waiting a couple of years, during which time you work on saving for a down payment and boosting your credit score. The best position you can put yourself in from the start, the more home you’ll be able to buy.