How much house can I afford?

When looking for a house, you should start by trying to figure out what your budget should be. The mortgage you can qualify for depends on how much debt a lender thinks you can reasonably afford to take on to purchase a house. The amount of money that you get approved for ultimately determines how big of a house you are able to afford. 

This article dives into the details of how to calculate how big of a house you can afford and learn more about what it means to take on a mortgage. Hopefully, after reading this, you'll be able to confidently begin the search for your dream home.

All About Budgeting

Buying a house is a huge decision to make, and it's easy to get overwhelmed by all of the moving parts. The first step to a smooth home-buying process is to set a realistic budget and be honest about what you can afford, especially with buyer demand and asking prices on the rise. 

It's crucial to hunt for homes that are within your budget only, so that you avoid falling in love with a house that you cannot afford. Look into different calculations to figure out a range of what you can afford. 

The Modern Lending online calculator can help you determine how much house you can afford, how much cash you'll need for your down payment, and how much your mortgage payments will be. 

In order for lenders to evaluate your application and figure out what you can afford, they calculate your debt-to-income ratio. This is your monthly mortgage payment to pay off your debt, divided by your monthly gross income. Lenders evaluate this number to see how much additional debt you could reasonably expect to take on.

There's a 29/41 rule that helps lenders evaluate your situation. According to the 29/41 rule, it's best to keep your debt-to-income ratio within a range that's defined by these two numbers. 

The first digit, 29, represents your housing expense ratio, which is calculated by dividing your mortgage payment (principal, interest, real estate taxes, homeowners insurance, and homeowners association dues and mortgage insurance, if applicable) into your gross monthly income and converting it into a percentage.

The second digit, 41, represents your total debt-to-income ratio after all your other debts are added, including revolving debt, like credit cards and installment debt. Then, subtract your mortgage, car payment, student loans, etc. 

Here is the formula breakdown:

(Principal + Interest + Property Taxes + 

Insurance (Homeowners & Mortgage) + Homeowners Association Dues)

________________________________________________     x 100

Gross Monthly Income

Although under many loan types, there are higher housing expenses and DTI ratios allowed, the 29/41 ratio is a good rule of thumb to start with. This will calculate how much house you can afford while maintaining a wide range of options for loans.

It's a good practice to make sure your mortgage payment, including principal, interest, taxes, insurance, and homeowners association dues, is no more than 29% of their gross monthly income. Furthermore, make sure that your total monthly debts, including your mortgage plus car loans, student debts and other debts don't exceed 41% of your total monthly income. 

Determining your Debt-to-Income Ratio

Debt-to-income ratio is an important qualifying factor for mortgage lenders to determine your eligibility. But, how is the DTI ratio calculated? Let's dive into the numbers.

First, add up all of your monthly debts. This could include monthly rent or house payments, monthly child support payments or alimony, student loan payments, car payments, monthly credit card minimum payments, and any other debts you might be involved in. You can disregard grocery bills, utility bills, taxes, and any other variable ongoing expenses.

Second, you're going to divide your monthly debts by your monthly gross income. As an example, let's say that your debts add up to $1,500 per month. If your monthly gross income (before-tax income) is $5,000 per month, then your DTI ratio is 30%.

What Else Plays a Role in Determining How Much House You Can Afford?

What we've covered so far is very important in determining your mortgage qualification, but there are a few other factors that come into play that impact how much you'll be able to afford when looking for a house.

Mortgage Terms

First, there are different mortgage terms to consider. 

The two most common mortgage terms are 15 years and 30 years, although there are other terms available as well. This impacts your monthly payments. 

Here's an example of a typical difference between the two payments:

If you buy a $1,000,000 home with a 15-year fixed-rate mortgage at 4%, your monthly payments will be $7,396.88.

But, if you change the term to 30 years for the same house at $1,000,000 at a 4% fixed-rate, then your monthly payment will be $4,774.15.

Once you close on a house and secure a mortgage loan, this will be your biggest payment each month, so it's crucial that you know you can afford it. This is why there are different terms to choose from. Clearly, choosing the 15-year term is more expensive in the short term, but you will end up paying much less than the 30-year term in the long run.

Mortgage Interest Rate

Like terms, there are also varying interest rates for mortgages. The mortgage rate refers to the interest rate that is tied to your mortgage's monthly payment. The rates are determined by the lender that you go with, and this can be either fixed or variable. Essentially, the rate can stay the same or change depending on external factors, like your credit score, down payment, and other things. 

Let's bring back the example from the previous section. If you bought a house for $1,000,000 with a 15-year fixed mortgage interest rate of 3.25% instead of 4%, it would take the payment down from $7,396.88 to $7,026.69. The variability of interest rates plays a huge factor in determining the affordability of a property, since a lower interest rate makes the house's monthly payments much cheaper.

Reserves

If you lost your job or another life-altering event happened, would you still be able to make your monthly payments from your savings? This is your reserves, or your emergency savings. In general, it's a best practice to keep at least 2 months worth of monthly expenses in your savings account, just in case.

In order to successfully save up enough money for an emergency, you'll need to track your budget for a few months, then decide how much is necessary for you to save up. This will also help you decide how much house you can afford.

Down Payment

The typical belief with down payments is that you have to put at least 20% down in order to purchase a home. But, that's not necessarily true. 

It does help your overall payments and interest rates to put down as much money as possible, but with a conventional loan, you could put down as little as 3%. These include loans backed by Fannie Mae or Freddie Mac. 

Furthermore, with some government loans, you might be able to buy a home with 0% down.

Additional Costs

There's a few other costs to take into consideration when looking to purchase a home. The obvious costs are a down payment and private mortgage insurance, but here's a few extra costs to think about:

• Property Taxes: Owning a property means you have to pay property taxes, which total up to the property's assessed value multiplied by the local tax rate. You can find this number by asking your local tax assessor for more details.
• Closing costs: While closing a deal on a property, you have to pay for closing costs. This is the last step to buying a property. Typically, the lender you work with will give you an estimate of how much your closing costs will be. This includes the loan origination fee, appraisal fees, title search fees, credit report charges and more. Most closing costs come out to somewhere between 3-6% of the price of the house.
• Homeowners Insurance: Depending on where you live, the house you bought, and the neighborhood you're in, your homeowner's insurance cost will vary. This calculation also considers the value of your property as well as the value of your at-risk assets and potential rebuild costs. Calling an insurance agent is the best way to get an accurate idea of what your homeowners insurance will likely amount to.

At the end of the day, you will be in charge of agreeing to a certain price, depending on what you think that you can afford. The search to find the perfect home is an exciting process, and evaluating your financial situation to figure out a budget can help make everything run smoothly.

It's okay to feel intimidated by the home buying process and if you have questions Modern Lending offers information about every step of the homebuying process. Visit our website for more information on mortgages and how you can get one step closer to buying your dream property today!