It’s easy to daydream about your ideal home. It’s much harder to make it reality, especially if you don’t know how much home you can afford when you need a mortgage to make the purchase.
The general rule of thumb is that you shouldn’t spend more than 30% of your gross income on housing—including taxes and insurance. But, in an environment of rising home prices and rents, the average American exceeds that, putting 33% of their income towards shelter, according to government data.
What is the financially prudent strategy? Here is what you should consider.
What your mortgage lender expects
Believe it or not, your mortgage lender is a lot more lenient than you might expect when it comes to your ability to buy a house. You can get a home by putting down as little as 3% toward the purchase price—as long as your credit score and income are up to snuff.
Lenders also consider the amount of your monthly debt payments including your hypothetical mortgage payment and how that compares to your income, typically expressed as debt-to-income (DTI) ratio—which is the total monthly debts divided by gross monthly income. If you’re carrying too much debt each month, that can disqualify you. Here’s the max DTI allowed, depending on type of mortgage:
Of course, just because you can spend up to half—or more—of your income on debt payments including your housing payment, that doesn’t mean you should, says Sarah Graham, a financial advisor at VLIP Financial Advisors in Vienna, Virginia.
“If buying a more expensive home means a homeowner will have to put off saving for retirement; stop contributing to their children’s college funds; or go too long without an emergency fund,” she says, “then they have spent too much.”
What you can really afford each month
Many financial experts prefer you stay well below the max DTIs outlined by mortgage lenders. When making large purchases, consider these guidelines that many advisers follow, says Sallie Mullins Thompson, a certified financial planner in New York.
- Non-housing, consumer debt payments should not exceed 20% of after-tax monthly income.
- Housing costs—including mortgage, maintenance, utilities and insurance—should not exceed 28% of pre-tax monthly income.
- Debt-to-income should not exceed 36% of pre-tax monthly income.
Going over these leaves little wiggle room for life’s extras. “It's goodbye to vacations. When the house is purchased on the basis of two people's income at the limit, it means that neither party can take time off to be with children,” says Chris Chen, a certified financial planner in Boston.
Older buyers nearing retirement should consider how much of their post-retirement income will be needed to pay for their mortgage payment, if they plan to stretch for that bigger but won’t pay it off before their golden years. The average over-65 household spends 42% of income on shelter, a share that could crimp retirement plans.
Exceptions: “So when is it ok to spring for a pricier home?” asks Graham. If you or your spouse expect a significant increase in income while expenses remain the same—such as a resident-soon-to-turn-doctor or a spouse returning to work—then you could go for the more expensive home. Another scenario: If you expect a major decline in expenses such as childcare or college tuition, you may be able to afford the bigger price tag.
Translating a monthly payment into a home price
Now that you know how much you can afford to pay each month for a mortgage, how does that translate into an actual home price? Keep it simple, says Scott Sheldon, branch manager of New American Funding in California.
“I tell someone for every $100,000 of purchase price, it’s a $600 monthly payment,” he says, noting that’s for a 20% down payment. That means if you can afford $2,400 a month, you can buy a $400,000 house.
But many buyers—especially first-time ones—put less than 20% toward the purchase price. In that case, your monthly costs will increase in two ways, which you’ll need to consider when finalizing how much house you can afford.
The first is that the principal and likely mortgage rate—and thus your monthly mortgage payment—will be higher, since the down payment covers less of the home’s cost. The lender will also require you to buy private mortgage insurance to minimize its risk if you default on the mortgage. Sheldon says to roughly calculate $700 to $750 a month per $100,000 for these additional expenses.
If the amount you can afford each month isn’t enough to buy an adequate home in your area, consider paying off your debt with the largest monthly payment and lowest balance. That will reduce your debt obligations in your DTI. Alternatively, contribute a larger down payment, if possible, which will reduce your monthly payment and either lower or eliminate mortgage insurance.