How much house can I afford? You can afford a home that costs 3 times their annual income. That’s the quick answer, but if you are seriously consider buying a home, you need to ask these three questions:
- Can I buy a house?
- Should I buy a house?
- How much house can I afford?
Can I buy a house?
Home buyers are often unsure what it takes to buy a home. Since most home buyers will need a mortgage to buy a home, the answer to the question “Can I buy a home?” almost entirely depends on the answer to another question: “Will a bank approve my mortgage loan application?”
Most people don’t have enough cash to buy a home, so they’ll need to borrow the money to buy their home. Mortgage loans are different than other types of loans. A mortgage is tied to the home you are buying. If you fail to make your monthly mortgage payments, the bank can take your home through foreclosure.
When banks are reviewing your mortgage application, they care about your credit history, your down payment amount, and your Debt-to-Income ratio (DTI). You’ll be in pretty good shape for a mortgage approval if:
- your credit score is higher than 680
- your down payment is higher than 3% of the home price
- your Debt-to-Income is less than 36%.
Let’s go through each of these.
Credit Score
A credit score is a number between 300 and 850 that is based on your credit history. This score gives banks an indication of how you’ve done, in the past, as far as paying back your loans, including student loans, credit card balances, auto loans, and mortgages. The higher your score the more likely you are to pay your loan payments on time. If you’re credit score is above 680, you have a solid shot the bank approving your mortgage application.
Down payment
A down payment is an amount you must pay the day you buy your home. Your down payment, along with your mortgage loan will cover the price of the home. Down payments are important to banks because this represents your “skin in the game”. Although, many people believe you must make a 20% down payment in order to buy a home, this is a common misconception.
In fact, banks may approve you for a mortgage if you make a 3% down payment. As an example, if you’re interested in buying a home for $200,000, a 3% down payment would be $6,000.
Debt-to-Income
Your Debt-to-Income ratio is the total amount you pay in monthly loan payments divided by your monthly income (before taxes and deductions; not your paycheck amount). For example, if you make $4,000 a month and all your monthly loan payments, including your mortgage, add up to $1,000, your Debt-to-Income would be 25% ($1,000/$4,000). Bundle suggests you target a Debt-to-Income of 30%. This way you have a little room with most lenders in case some of your income does not qualify or you find a home that you love that’s more than your target home price. If your Debt-to-Income is less than 36%, you have a solid shot the bank approving your mortgage application.
Should I buy a house?
Just because you can buy a house, doesn’t mean you should buy a house. Here are some good guidelines to help with your decision.
You should seriously consider buying a home, if:
- you met the above criteria for mortgage approval, 680 credit score, 3% down payment, 36% Debt-to-Income
- you’ll live in the home for more than four years
- you’ve built up an expense cushion
- you’ve paid off all your high interest debt
How Long Should You Live in the Home You’re Buying?
You should plan on living in the home you are purchasing for at least 4 years.
The transaction costs of buying a home can add up quickly. You’ll need to pay attorney fees, appraisal fees, title insurance, and lender fees. You also must consider movers, blinds, furniture, and initial home repairs. If you sell after a year, you’ll have to pay a real estate agent a 6% commission. These costs can eat away at any short-term home price appreciation and are more easily absorbed over a longer period.
Another benefit of living in the house a little longer is that your home price appreciation will be more stable over a longer period. Yearly fluctuations in the housing market always exist, but there is a historical long-term positive trend.
Do You Have an Expense Cushion?
You should have 3 months of salary set aside to cover unforeseen events.
Building up an expense cushion can be more beneficial to your long-term financial health than almost anything else. You need to make sure you can cover your basic living expenses if you lose your job or have an unexpected expense. Make sure you are able to cover things like food, gas, and your housing payment.
You should prioritize an expense cushion before you start paying down any debt. Missing loan payments can have a more serious long-term impact on your credit score than having a credit card balance. Missing payments today will cause your credit score to plummet and increase the interest you’ll pay on any future loans you decide to take out. In the worst-case scenario, banks won’t be able to lend you money at all when you apply for a mortgage or other loans in the future.
What Are Your High Interest Loan Balances?
Pay off your high interest loans before you buy a home.
Compare the interest rates of your other loans to the market mortgage rate. If they are more than 5% higher, you should pay those balance down to $0 after you build your expense cushion and before you buy a home. Let’s assume you make $60,000 and have already set aside a $15,000 expense cushion ($60,000 ÷ 12 months × 3 months cushion = $15,000). If you have an $5,000 in credit card debt and the interest rate is 20% compared to the market mortgage rate of 5%. The difference ($20% – 5% = 15%) is more than 5% so you should pay off your credit card before you buy a home.
How much house can I afford?
You should target a 30% Debt-to-Income ratio.
If you have determined, you can buy a house, and you should buy a house, it’s time to figure out how much house you can afford, and the best starting point is 30% Debt-to-Income. This takes 2 steps. First figure out how much your monthly mortgage payment will be at a 30% Debt-to-Income. Then figure out how much that translates into a home price. Bundle has a great budgeting tool that walks you through both of these steps.
Monthly Mortgage Payment Calculator
For example, if you make $60,000 a year, you can spend $1,500 per month on debt payments ($60,000 ÷ 12 months × 30% Debt-to-Income = $1,500). If you have a $300 car payment and a $100 student loan payment, you can spend $1,100 each month on your mortgage payment ($1,500 – $300 – $100 = $1,100).
Home Price – How Much House Can I Afford?
Multiply your monthly payment by 150. In our example, you would be able to afford a $165,000 house ($1,100 X 150 = $165,000). This assumes a market mortgage rate of 4.5%, a 10% down payment, and a home in an area with 1.3% annual property taxes.
What can make this amount go higher than $165,000?
- A more aggressive Debt-to-Income target. Some banks can lend up to a 43% Debt-to-Income. Be careful not to stretch your budget.
- A higher down payment. This lowers your interest and mortgage insurance.
- A lower market interest rate
- A lower property tax rate
- A lower car or student loan payment
What can make this amount go lower than $165,000?
- A more conservative Debt-to-Income target.
- A lower down payment. This increase your interest and mortgage insurance.
- A higher market interest rate
- A higher property tax rate
- A higher car or student loan payment
- Home Owners Association Dues
Now that you know what to look out for, Bundle hopes you find a house you can afford.