Buying a home is the biggest financial decision many people ever make. So it’s not a decision to be taken lightly.
Whether you’re moving from a rental to your first house, looking to move out of your starter home, or thinking about buying that forever piece of real estate, you’ll need to have a good sense of your financial situation.
Before signing the dotted line, you want to know your monthly mortgage payment, homeowner’s insurance and property taxes. You need to consider other monthly expenses, like student loan payments, credit card debt, car loans – making sure you can cover them on your annual income along with that new mortgage payment. And that’s just the beginning.
So let’s walk through many of the factors you’ll need to consider before you can answer that all-important question, “How much house can I afford?”
Calculate Your Housing Budget
While it can be tempting to immediately start browsing the listings, the first step in this process is knowing your housing budget. To figure that out, take these into consideration:
- Your monthly income and take-home pay.
- The size and terms of the mortgage loan you’ll take out.
- The size of your down payment.
- The ongoing costs of homeownership.
How Much Money Do You Actually Take Home?
The first order of business when making a budget is to determine how much of your income is available to you.
In general, your salary refers to the full amount you earn (your gross income) rather than the amount you take home (your net pay). There are several deductions taken out of your paychecks for things like taxes, insurance and retirement contributions, depending on your workplace.
When you think about how much house you can afford, you should think about your net pay, because that’s the real number you’re dealing with.
Knowing your take-home pay will help give you an idea about what size monthly house payment you’re comfortable with. You’ll need to factor in other debt payments, like a car loan or student loan payments. You’ll also need to think about other variable expenses, like how much you spend on entertainment or eating out, to see how much breathing room you have in your monthly budget.
Most experts recommend spending no more than 25% of your take-home pay on your home. Keep in mind that lenders might approve you for more. But don’t let the offer of a bigger loan tempt you into spending more than you’re comfortable with.
And don’t forget — an emergency fund will be more important than ever when you own a home. Financial experts advise having at least three to six months worth of expenses saved up so you can cover your bills in the event of a job loss or other crisis.
How Lenders Evaluate Your Income and Monthly Payments
For all that talk about net pay and take-home pay, here’s something to keep in mind: That number is mainly of interest to you. Banks and mortgage lenders will generally look at your gross pay to determine what’s known as your debt-to-income ratio, or DTI.
The basic formula for your debt-to income ratio is this:
DTI = Monthly debt obligations/Monthly pay
When calculating for budgeting purposes, you’ll use your net monthly pay – the amount on your paycheck after taxes and withholdings. That’s your consumer DTI.
But lenders prefer your overall DTI – the one that uses your gross (or pre-tax) monthly pay. Also, keep in mind the overall DTI doesn’t include monthly expenses like groceries, gas and utilities. It basically includes the items that will show up on your credit report.
So what’s a good DTI? Most experts agree 35% is a healthy ratio, meaning your debts are under control and you’re a good candidate for a loan. For mortgages specifically, 43% is generally considered the upper limit for getting approved.
Determine How Much Down Payment You Can Make
The next step in figuring out how much house you can afford is sizing up your down payment. The amount of money you put down on a home purchase directly affects the overall cost of your mortgage loan.
The more your down payment, the less you’ll have to borrow. With that in mind, most experts recommend 10% as a minimum down payment.
But to really reduce your monthly payments, you should aim for at least a 20% down payment. By doing that, you won’t have to pay for private mortgage insurance, or PMI. Mortgage insurance is required by most lenders as a protection against you defaulting on the loan. It typically costs between 0.5% and 1% of your entire mortgage value, and it’s added onto your monthly payments.
You can request to have your PMI terminated once you reach a loan-to-value ratio at or below 80%, meaning you own at least 20% equity in your home and are less likely to default. (When your loan-to-value ratio falls below 78%, your PMI will be canceled automatically.)
So by putting down at least 20%, you start out at that 80% threshold and never have to pay for PMI.
Here’s how that can affect your monthly payment:
Let’s say you put a 20% down payment on a $200,000 house. That leaves your total loan amount at $160,000. On a 15-year loan with a 3% interest rate, your monthly payment (principal and interest) would be $1,105.
A 10% down payment would make your monthly payment $1,243 per month, plus at least another $67 a month for PMI, for a total of $1,310.
And nothing down at all would result in a $1,381 monthly payment, plus $67 for PMI. Total: $1,448.
(Keep in mind that all of those figures don’t account for property taxes or homeowner’s insurance.)
So, by making a 20% down payment, you’re financing less, which results in long-term savings on interest, but also keeps your monthly payment down by exempting you from paying mortgage insurance.
How to Line Up Your Financing
Next, you’ll need to find a lender. Look online for the best interest rates and talk to friends and family for their suggestions.
Then, get that pre-approval letter. This is an official document that says the lender is committed to giving you a loan, assuming nothing changes in your finances. Getting preapproved takes a little more time and effort because the lender will want to see many financial documents, like W-2s, pay stubs, tax returns, to verify that you’re reliable.
You’ll be more attractive to lenders if you can prove at least two years of continuous employment, have a good credit history over the last 12 months, and have enough funds on hand to afford a good down payment.
Understanding How Your Mortgage Works
As you shop for financing, and even once you’re locked into a mortgage, it’s important to understand how your loan works. Here’s a guide to some common terms.
Your monthly mortgage payment is the installment you pay every month for the length of the loan, determined by the loan term, interest rate and principal:
Term: The loan term is how long it will take you to pay back both the principal and the interest. The average term of a U.S. mortgage is 30 years, but you can also get 20- and 15-year loans — though those will come with higher monthly payments since you’re paying the loan back in less time.
Principal: This is the purchase price of your home minus your down payment. It’s the amount you’re borrowing.
Interest rate: This is the amount charged by your lender to finance your home loan as a percentage of your loan balance. Mortgage loans use compound interest, which is calculated every month based on the remaining balance of the loan. Obviously, the lower the interest rate, the lower your mortgage payment, and the less you’ll pay over the length of the loan.
The Difference Between Adjustable and Fixed Rates
When you shop for a mortgage loan, you’ll find several different types. Here’s what to look for in fixed and adjustable rate loans as you determine how much house you can afford:
Fixed Rate: With a fixed-rate loan, interest rates are locked in. If it starts at 4.5%, it will always be 4.5%. For homebuyers, this means that if you can get a fixed-rate mortgage when rates are low, you’ll pay less overall. This is the best option in most cases.
Adjustable rate: If you opt for an adjustable-rate mortgage, then after a set period of time with a fixed rate, your interest rate can change if the market does. There are very few situations in which this is a better option than a fixed-rate loan.
FHA Loans, VA Loans and USDA Loans
In addition to the standard 30-year and 15-year loans, you might have other options.
FHA Loans: These are government-backed loans that might be an option for lower-income buyers or individuals with lower credit scores. FHA loans allow you to have a credit score as low as 500, and you can also make a down payment as low as 3.5%, making them attractive for first-time homebuyers.
VA Loans: These loans are available for military service members and veterans and are backed by the Department of Veteran Affairs. VA loans require no down payment or mortgage insurance. However, these loans do require a VA funding fee that changes annually.
USDA Loans: These loans are backed by the U.S. Department of Agriculture and are mainly for rural borrowers who can’t qualify for traditional loans. No down payment is required, although there are income and property value limits.
Closing Costs: How They Work and Who Pays Them
Closing costs are fees and expenses you pay when you complete your home purchase. Since they aren’t included in the sale price, they can catch a lot of first-time buyers off guard.
Like the down payment, they often need to be paid in cash, and will cost between 2% and 5% of the price of the home. So if you’re buying a $200,000 home, you can expect paying somewhere in the neighborhood of $4,000 to $10,000 in closing costs.
Closing costs cover a litany of things such as lawyers and title fees and taxes on the transaction.
Keep in Mind the Ongoing Costs of Homeownership
When you buy a house, you need to budget for annual and monthly expenses to keep your home in good working order and keep you in good standing with creditors.
Property Taxes: Cities and counties set their own property tax rate for services like road upkeep, libraries and parks. Annual taxes are calculated based on the value of your house. Many lenders pay the taxes for you, then roll them into your monthly loan payment.
When you’re looking for a new home, you will generally see an annual tax rate included on the listing. That number is just an estimate and can change each year when your city or county sets new tax rates.
Regardless, it’s a good approximation, and if you divide it by 12, you can get a sense of how much it will add to your monthly payment.
Homeowners Insurance: You should never go without homeowners insurance. It protects your home and possessions from disasters, damage and theft, and provides liability protection for you in case of an accident on your property. If you have a fire in your house, your insurance will pay to repair it and may even pay for your housing costs elsewhere while your home is being fixed.
Homeowners insurance rates vary by region and state. Homeowners in areas prone to natural disasters, like hurricanes in Florida and wildfires in California, will pay more. The age, condition and size of your home will also affect how much you pay.
Home repairs and maintenance: A good rule of thumb is to save about 1% to 2% of your home’s value each year for future maintenance and costs for things like the HVAC, roof, major appliances and so on. For a $200,000 home, this is about $2,000 to $4,000 per year, which comes to about $167 to $333 per month.
You’ll also need to think about other monthly expenses, such as HOA fees, lawn care, pest control and home security, when factoring in the total monthly costs of your home.
How Much House Can You Afford? 4 Scenarios
So let’s break it all down into four different scenarios for a couple who has an annual gross income of $100,000 with a monthly take-home of $5,660. Twenty-five percent of their monthly income comes to $1,415, so that’s how much they have to work with on a monthly mortgage payment.
They’ve locked in on buying a beautiful home for $260,000 with annual property taxes of $3,000 and insurance of $1,000.
Scenario 1: A standard 30-year mortgage with a 20% down payment.
Mortgage Term: 30 years
Interest rate: 3.8%
Down Payment: $52,000 (20%)
Principal and Interest: $932/month
Monthly Insurance: $83
Monthly Taxes: $250
Monthly PMI: $0
Total Monthly Payment: $1,265
Scenario 2: A standard 15-year mortgage with a 20% down payment.
Mortgage Term: 15 years
Interest rate: 2.9%
Down Payment: $52,000 (20%)
Principal and Interest: $1,371/month
Monthly Insurance: $83
Monthly Taxes: $250
Monthly PMI: $0
Total Monthly Payment: $1,704
Scenario 3: A standard 30-year mortgage with no down payment.
Mortgage Term: 30 years
Interest rate: 3.8%
Down Payment: $0
Principal and Interest: $1,371/month
Monthly Insurance: $83
Monthly Taxes: $250
Monthly PMI: $108
Total Monthly Payment: $1,653
Scenario 4: A standard 15-year mortgage with no down payment.
Mortgage Term: 15 years
Interest rate: 2.9%
Down Payment: $0
Principal and Interest: $1,371/month
Monthly Insurance: $83
Monthly Taxes: $250.
Monthly PMI: $108
Total Monthly Payment: $2,224
For our example couple, their best option is scenario 1: The 30-year traditional mortgage with a 20% down payment. The others fall above their monthly housing budget. They’ll need to save up $52,000 as a down payment if they don’t already have that available in savings.
As you can tell, a 20% down payment makes a huge difference on the monthly payment in these scenarios. It also gets rid of that pesky $108 PMI payment every month. The 15-year mortgage also cuts those monthly payments down a noticeable amount and allows them to pay off the house much faster.
Robert Bruce is a senior writer at The Penny Hoarder.
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