How Much House Can You Afford?

When buying a home, especially your first, it can be so easy to get wrapped up in a frenzy of what kind of carpets are in the home, how many windows the house has, and what other amenities make a house the home of your dreams. The reality however is that the question you should be asking yourself is ‘how much house can I really afford?

As housing and mortgage laws are changing, getting stricter because of the increase in loan defaults, it is a very important first step to figure out exactly what you can afford before even beginning the home search. And above all else, never base what you can afford on what your mortgage broker tells you.  Chances are, he has no idea.

Calculating Home Affordability

Mortgage Percentages

The rule of thumb you’ll need to remember is that your monthly mortgage payments should not exceed 28% of your gross income before taxes. If your combined income is $60,000, your mortgage payment should not go over $1,400 a month. ($60,000/12 months = $5,000 x 28% = $1,400)

Total Housing Percentages

Following the 28% rule, you will also need to factor in with the mortgage the additional expenses of owning a home such as property taxes, insurance, and other monthly fees. This total amount should not exceed 32% of your gross monthly income. At $60,000, the total cost of housing each month should be no more than $1,600.

Debt Percentages

After the first two rules, debt will also be factored into the equation. You’ll need to have a solid understand of how much financial liability you have each month. This includes all of your monthly bills including credit card debt, student loans, vehicle notes, insurance, and the like. Total them up and compare against your gross monthly income. The amount should not exceed 40% of your gross monthly income. In our scenario, total monthly debt payments in excess of your housing expense should not be more than $400.

Interest Rates And Down Payments

You will need to calculate your total amount of your mortgage but the interest rate on the loan will be the deciding factor. Until you know what the rate will be, make a guesstimate based on your credit score and the current APR’s to find out exactly how much mortgage you can afford. To find formula for calculating the maximum amount for our scenario, let’s assume you take out a 30 year loan at a 6% fixed rate. For every $10,000 borrowed, your mortgage payments would be around $55. $1,400/$55 = 25.45 x $10,000 = $254,500.

After calculating the numbers, you will also have to factor in the amount of your down payment. Most lenders want to see 20% of the purchase price down. Anything less than 20% will bring an added expense of private mortgage insurance, or PMI, which is required when you have less than 20% equity in your home. PMI payments will decrease your debt expenses and the total amount of home you can afford.

Working through these calculations before shopping for a home or a mortgage will give you a better understanding of where to start looking and save you money for the long-run because you already know what you can afford.  And remember, the numbers above represent the maximum recommend purchase price.  You should of course try to purchase a less expensive home and under no circumstances should you purchase a more expensive one.