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The most expensive purchase the average person makes in their life is a home — so it’s a stressful endeavor, to the say the least. The current state of affairs isn’t making it any less stressful.
With so much economic uncertainty, it’s understandable if you’re hesitant about moving or making your first home purchase. But you can assess your home-buying budget without committing to anything. And if you decide you’re not ready, you can take steps now that will help you be better prepared in the future, like strengthening your credit or saving for a bigger down payment.
This is a tactic an increasing number of home buyers and sellers have taken during the pandemic. Across the U.S. this spring, the number of new listings and homes for sale went down year over year. At the same time, lenders began scrutinizing borrowers’ employment status more closely and raising requirements for credit scores and down payments. Many buyers have been forced to the sidelines.
As a chunk of the housing market shifts into “wait and see” mode, now is a great time to be proactive with your home-buying budget.
Why Having a Budget Is Important
Only once you have a sense of your overall budget — how much you have coming, going out, and in savings — can you consider what you might spend on a new home purchase.
“The best advice I give is to buy a home you can afford,” says Eric Chen, a financial consultant and associate professor of business administration at the University of St. Joseph. “But you’re not going to know what you can afford until you budget.”
When you’re calculating your home-buying budget, leave room for unexpected expenses. The most expensive home you can afford isn’t necessarily the one you should buy.
How Much House Can I Afford?
Your bank or mortgage lender can help you estimate how much your new home purchase will cost in terms of monthly payments, ongoing expenses like private mortgage insurance, and up-front fees such as closing costs. You can get ahead of the process by using a mortgage payment calculator. Be sure to have your income, estimated down payment, and other financial information ready to go.
Note that the number you are approved to spend by your lender is the maximum you should consider paying for a home. You’re probably better off shooting for an amount below the maximum. “I always recommend people try to avoid buying right at the high end of their budget,” says David Pipp, who runs the family financial website Living Low Key. “You don’t want to be strapped for cash and have an emergency come up you can’t pay for.”
“A good rule of thumb to follow is the 28/36% rule,” says Austin Weyenberg, founder of the personal finance blog The Logic of Money. “This means your monthly mortgage payment should be no more than 28% of your pre-tax income, and your total debts should be no more than 36% of your total pre-tax income.”
Molly Ford-Coates, an accredited financial counselor and the founder and CEO of Ford Financial Management, is even more conservative. “I tell people their housing expenses shouldn’t exceed more than 25% of their gross monthly income, and their total mortgage should not exceed more than two to two and a half times their annual income.”
In the end, the answer to the question “how much mortgage can I afford?” is a personal one. If you’ve done the necessary homework to ensure you’re not getting in over your head and have enough money in reserve for emergencies, you can come up with a reasonable number for what percentage of your income should go to housing.
Interest Rate Impact on Your Budget
Your interest rate plays a bigger role in your payment than may you realize. Consider this example, using our mortgage calculator:
|Payment Details||Payment Amounts|
|Down payment||$60,000 (20% of the purchase price)|
|Loan period||30-year fixed rate|
|Your monthly payment at 2.500%||$1,241|
|Your monthly payment at 5.000%||$1,581|
|Savings per month with lower interest||$340|
Imagine being able to put away an extra $340 in savings each month, which would yield you savings of more than $4,000 annually. For this reason, it pays to shop around for the best interest rates.
To see exactly how different interest rates will impact how much house you can afford, you can use our mortgage payment calculator.
How Debt-to-Income Ratio Impacts Your Budget
How much you can borrow to buy a home depends on your income and credit score, as well as your debt-to-income ratio (DTI). This is calculated by taking all of your monthly debt payments and dividing that by your monthly pre-tax income.
Your DTI usually includes bills like student loans, car payments, and credit card debt, but it doesn’t include living expenses such as food, gas, and utilities. While the maximum DTI varies by lender and mortgage type, most lenders require a DTI of 36% or lower.
For example, if you have a pre-tax monthly income of $4,000, 36% of that would be $1,440. So your total debt payments and future mortgage payment couldn’t exceed that amount. But just because a bank is okay with letting you borrow up to a 36% DTI, or more, that doesn’t mean you should.
Low Down Payment Mortgage Options
One of the biggest barriers to homeownership is the upfront costs, including the closing costs and down payment. Typically, the down payment is the biggest out-of-pocket expense. For a conventional mortgage it can be as high as 10% to 20% of the purchase price.
However, there are government-secured loans that are less risky for lenders and therefore have small down-payment requirements. These mortgages also typically have less strict lending guidelines and can be easier to qualify for.
Mortgages backed by the Federal Housing Administration (FHA) require as little as 3.5% down. That can save you tens of thousands of dollars in upfront costs.
But FHA loans require that you have mortgage insurance throughout the life of the loan if you have a down payment of less than 10%. This costs .45% to 1.05% of the loan amount annually. That’s in addition to an upfront insurance premium payment of 1.75% of the mortgage amount, regardless of your down payment amount. With conventional loans, you can waive the mortgage insurance requirement once you have 20% equity in your home.
FHA loans are more accessible, but they can be more expensive in the long run.
If you have qualifying military service, you may be eligible for a mortgage backed by the U.S. Department of Veterans Affairs, also known as a VA loan. This loan type has no minimum down payment requirement, so you can borrow up to 100% of your future home’s purchase price.
However, VA loans do have a unique upfront funding fee of 1.4% to 3.6% of the purchase price. And with no down payment being required, your funding fee may end up being closer to 3.6%. That can be a significant out-of-pocket cost — but you may be able to roll the funding fee into your loan. In that case, you’re even allowed to borrow more than 100% of your home’s value.
The question at that point becomes whether or not it’s the right financial move for you to borrow more than what your home is worth.
The Final Word
Know the elements that go into your mortgage payment and what you can save by shopping for better interest rates.
Be realistic: All our experts suggest you shop below the maximum amount you can qualify for. Consider your lifestyle, your existing debts, and current and potential income when shopping for homes. If you buy a home taking every penny of your disposable income, you may be caught short in an emergency.