You’re likely aware that homes these days cost astronomical sums, with the median home price nationwide hovering at $375,000—an increase of 10% from a year earlier.
Daunting? For sure. Yet if you’re pondering a home purchase right about now, the more important number to know is this: How much home can you afford?
The answer to this question is all the more critical in today’s red-hot, warp-speed market, where you won’t stand a chance without a clear picture of your finances. If all you have is a hazy idea of what you can pay, home sellers will have a hard time taking you seriously. Worse yet, you might get swept up in a bidding war on a home and win—only to find out afterward that you’ve committed to a price beyond your means. Yikes!
The key to achieving homeownership today is to have a bull’s-eye focus on what’s within your financial reach—and vow to not spend a penny more.
“Head into a house hunt with your numbers in hand. Know your top number,” says Jay Zigmont, certified financial planner and founder of Live, Learn, Plan. “If you can afford a $250,000 house, don’t look at $300,000 houses. You will by nature like the $300,000 houses better and start rationalizing spending more.”
Of course, this top number is different for everyone, and while figuring it out might seem daunting, it actually boils down to just a few simple rules. Here’s how to get a handle on your homebuying budget so you can find home that’s priced just right for you.
How large a mortgage can you afford?
While most homeowners will make a sizable down payment on a house (typically 3.5% to 20% of the property’s price), the rest of the money is typically borrowed in the form of a mortgage, which is paid back to the lender every month, plus interest, for up to 30 years.
Although paying for a house in increments sounds much more manageable than coughing up the whole kaboodle upfront, lenders will still want to see that you have enough money rolling in to cover the monthly bill.
“Banks commonly allow up to 28% of your gross income before taxes as your monthly house payment,” says Zigmont.
Let’s say, for instance, that every month you’re pulling in $6,000 before taxes. That means $1,680, or 28%, is the maximum amount that can go toward monthly housing payments. Keep in mind that this should include not just your mortgage, but all housing expenses, including property taxes, home insurance, and mortgage insurance (if you have it), many of which get rolled into your monthly payments.
What is debt-to-income ratio?
While up to 28% of your income can go toward housing, this is likely not the full picture, since you might have other debts such as credit cards or college loans. Your overall debts, compared with your income, define your debt-to-income, or DTI, ratio.
To figure out your debt-to-income ratio, tally up how much you pay monthly toward debts like car payments, credit cards, and student loans. Once you have that number, divide that amount by your monthly income.
Let’s revisit the scenario of a homebuyer who’s making $6,000 per month pre-tax, but factor in that the homebuyer is also paying $500 per month to debts. Divide $500 by $6,000, and you have a debt-to-income ratio of 0.083, or 8.3%. That’s fairly low; however, if you add in a monthly mortgage payment of $1,500, you’d then divide $2,000 by $6,000 for a DTI ratio of 33%.
So just how high should a DTI ratio go when you buy a home?
“Lenders usually look for a debt-to-income-ratio of 36% or less when underwriting your loan,” says certified financial planner Anthony Carlton, who’s also vice president and wealth adviser at Farther Finance. This means that all your debts, including a house payment, should total no more than 36% of your pre-tax income.
That said, in today’s crazy market, staying under that threshold may be nearly impossible in certain areas. If this is the case with you, certified financial planner Louis Barajas thinks it’s fine to nudge this ceiling up a bit.
“Don’t go past 40% of your income in terms of all debt,” says Barajas, president and partner at MGO Private Wealth. Particularly, “if you are debt-free, you might put a bit more toward your housing costs.”
How a home affordability calculator can help
If all these numbers are making your head hurt, you can turn to an online home affordability calculator for help. Just plug in your income, debts, and down payment, and you will get an instant snapshot of what price home you can afford that will keep you within the recommended 36% DTI range.
In the aforementioned example where a homebuyer makes $6,000 a month and pays $500 in debts, let’s assume the homebuyer has $30,000 for a down payment and a good credit score. This will put the buyer in the ballpark of affording a home worth $263,400.
This home price will adjust, of course, alongside changes to your financial circumstances. Let’s say you were given a raise and now make $8,000 a month. Take those same numbers above ($500 in monthly debt and a $30,000 down payment), and you’d be able to afford a home worth $360,300. Or let’s say you make $8,000 per month and are able to whittle your debt down to $250 per month. That would mean you can afford a house worth $395,200.
Why mortgage pre-approval is a good idea
While crunching your numbers on a home affordability calculator is a good start to get your bearings, this is just a ballpark figure of how much home you can afford. If you want to get a more precise estimate, talk to a lender about getting a mortgage pre-approval. This is where a lender scrutinizes your finances and then agrees to loan you a certain amount of money to buy a house.
Since lenders won’t loan you more money than they think you can easily pay back, pre-approval is a good way to gauge what home price you can pay. Another nice bonus is that a pre-approval letter shows home sellers you’re serious and can follow through on your offer—an important edge if you’re bidding against other buyers who haven’t taken this step.
That said, no matter how much money a lender is willing to loan you, keep in mind that you know your finances best. Run your own numbers, taking into account not just your income and debts, but also every possible expense or potential scenario you see coming down the pike.