By Ben Luthi
While mortgage lenders place limits on how much you can borrow for a home based on your income and other debts, it’s also crucial that you think about your budget and how much you can actually afford to pay every month. So if you’re wondering “How much house can I afford?”, here’s what you need to know.
How to calculate how much house you can afford
1. Calculate your income vs. expenses
Write down how much you earn every month. Depending on your situation, your only source of income might come from a job, or you might have multiple sources, such as self-employment income, alimony, child support, Social Security income, or retirement income. While lenders look at your gross income to help determine how much you can afford, using your take-home pay will give you a more accurate picture of what you can pay every month.
Next, look at your expenses over the last few months and calculate how much you have leftover in your budget. Then, add that number to what you’re currently paying for housing, and that’s the maximum amount you can afford to pay.
2. Estimate the cost of housing
Take a look at what homes cost in your area and, using current market rates, calculate how much you’d pay monthly on a mortgage. Make sure you consider your down payment and closing costs to calculate the upfront expenses and monthly payment.
Remember that you’ll also have to pay property taxes and homeowners insurance premiums, which typically get added to your monthly mortgage payment. You can research property tax rates and average insurance premiums in your area to determine how much those might cost you.
If your down payment is less than 20 percent on a conventional loan or you have an FHA or USDA loan, make sure you incorporate mortgage insurance or guarantee fees into your estimation, as well.
3. Check your credit score
Your credit score has a big impact on your mortgage interest rate, so it can influence how much house you can afford. If your credit score is less than stellar, it might be better to take some time to work on improving your credit before you apply for a mortgage loan. To qualify for a conventional loan, you typically need a credit score of at least 620, but having a score in the mid-700s or higher is best if you want to qualify for the best rates available.
4. Figure out your DTI ratio
Your debt-to-income (DTI) ratio is a key factor lenders use to determine how much money you can borrow. If it’s too high, you might have difficulty buying the home you want. In this case, it’s a good idea to work on paying down debt before you apply for a mortgage loan. Use a DTI calculator to get an idea of how much of your gross monthly income goes toward debt payments.
5. Use a calculator
You can do the math all on your own, but if you’re hoping to save time and get an accurate picture of your financial situation, consider using a how much house can I afford calculator to crunch the numbers for you.
How much should I spend on a home?
There’s no one-size-fits-all answer to this question. Mortgage lenders have DTI thresholds and won’t allow you to borrow more than a certain amount based on your income and debt payments.
The standard DTI rule to consider is the 28/36 rule. This means that no more than 28 percent of your gross monthly income should go toward housing costs, and no more than 36 percent of your income should go toward total debt payments, including those housing costs.
For example, if your gross earnings are $5,000 per month, your housing payment shouldn’t exceed $1,400, and your total monthly debt payments should be under $1,800.
That said, some lenders will allow you to go higher — the highest you can go on a conventional loan is 50 percent.
Just because your monthly payment is under the threshold set by a lender doesn’t mean that’s how much you should spend, however. Take a look at your budget and other financial goals to help you determine what you’re comfortable with. If you max out your budget on housing, you could run into financial issues down the road.
How to afford more house
Depending on your situation, there could be ways to afford a more expensive house without putting your financial health at risk. These include:
Make a larger down payment. Taking more time to save up a bigger down payment will drive down how much you need to finance, lowering your monthly payment. You might even qualify for a down payment assistance program, so do your homework to see what’s available in your area.
Improve your credit. One of the best ways to lower your interest rate and, therefore, your monthly payment is to increase your credit score. Check your credit score and report to see where you stand, identify areas where you can make improvements, and then take steps to address them.
Pay off other debts. You can lower your DTI ratio and increase your cash flow available for housing by paying off existing debts. With credit card debt, you might consider using a balance transfer credit card or consolidation loan to help you achieve your goal, or you can simply use the debt snowball or debt avalanche approach.
Shop around. Each mortgage lender has its own way of determining closing costs and interest rates, so shop around and compare quotes from several lenders before settling on one.
Adjust your budget. Take a look at your expenses and see if there are areas where you can permanently cut back so you can make more room for the home of your dreams. Just remember that once you’ve reallocated that money toward a monthly mortgage payment, you can’t keep spending it on other things, so be reasonable with your budget-slashing.
As you take these and other steps to get your financial situation in order, you’ll be in a better position to buy the house that you want.
This article is also posted on Bankrate here.