A house is the largest single investment an individual or family will ever make. Think about it: What other asset comes with a six-figure price tag? Because a house represents such a large investment, it’s really important to calculate how much house you can afford.
While this might seem like a difficult task at first glance, there are simple rules of thumbs and guidelines you can follow to identify the home price that’s comfortably in your range. Here’s a look at those key decision factors as you determine how much house you can afford.
Look at Your Income
The amount you can afford to pay for a home is mostly a function of your income. In most cases, individuals and families can afford to pay between three and five times their annual gross income for a house.
So, if you and/or your family make $75,000 a year, you can typically afford homes that range between $225,000 and $375,000. Why such a large range? It all depends on your debt.
If you’re paying down significant debt (student loans, credit cards, car payments, etc.), you’ll want to spend closer to three times your annual income. If you’re debt-free, you can stretch up to five times your annual income.
Mortgage lenders approve loans based on what’s called a “debt-to-income ratio.” They add up all your monthly obligations with the potential home loan payment included, and then they divide that number by your monthly income. The resulting figure is your debt-to-income ratio, and lenders like to keep it below 40% in order to approve a loan.
Save for a Down Payment
To afford a home, you’ll also need to save for a down payment. The traditional down payment is 20% of the home’s sale price, which prevents you from paying private mortgage insurance (PMI) and gives you access to your best possible home loan rates.
So, using our example from above, you would need a $45,000 down payment for a $225,000 house at the low end of the range, and you would need a $75,000 down payment for a home at the high end of the range. Saving this much can be difficult, especially for first-time homebuyers who have no equity from a previous home. Don’t worry: There are home loan options that require lower down payments, too.
Consider Additional Costs
Here’s a catch: Even if you’re going to put down 20%, you’ll need more than 20% to close on a home transaction. Closing costs add to the size of the check a buyer will need to bring to closing, so shoot to save closer to 25% of the home’s value if you want to put down a 20% down payment.
Consider other costs when looking at your monthly house payment, too. For example, you’ll pay property taxes and homeowners insurance in addition to the principal and interest on your home loan. You’ll also need to pay for maintenance (caring for the lawn, trimming trees, maintaining important systems like heating and air conditioning, etc.) and repairs (plumbing issues, broken appliances, roof repairs, etc.).
Make sure you have enough money each month to cover all these costs, or else you won’t be able to relax and enjoy the lifestyle you desire in your new home.
How Will Your Situation Change in the Future?
One last thing: Before you buy a home, think about how your circumstances may change in the future. Perhaps you and a spouse are planning to have children, and one of you will need to stay home – reducing the amount of money you make each month/year. Or perhaps you’re looking to start your own business, which will mean reduced income for a period of time.
Most homebuyers make a decision based on how much they can afford in the moment. But home loans are commitments that typically run between 10 and 30 years. A lot can happen over the course of a decade or three, and you should make home-buying decisions that reflect how your life could change over the years.
Keep in mind, also, that you don’t have to make these decisions alone. I’m always here to answer any questions you might have (pthessen1@gmail.com). And I can also put you in touch with home lenders who spend each day delivering expert guidance to prospective homebuyers like yourself. Let us provide the support you need as you consider your housing options and how much you can ultimately afford.
-by Perry Thessen
