To buy a house, you will need to have cash for up-front costs and the ability to make monthly mortgage payments.
- Up-front costs include the down payment, closing/settlement costs, and some miscellaneous charges (e.g., lender fees).
- Monthly payments will include mortgage payments (interest and principal), as well as property taxes, mortgage insurance, and homeowners insurance.
How much house you can afford depends on the size of your down payment and the amount of loan you are approved for. The general rule is that you can afford a home that costs 2 to 3 times your annual household income (assuming you make a 20% down payment and have little/moderate debt). While that’s a nice guideline, if you are serious about purchasing a house you will need to establish your specific budget.
This article will help you determine the highest amount you can pay for a home based on your savings and income. You can work out the calculations on your own, or use the mortgage calculator (explained later in this article). Even though you probably won’t buy the most expensive house you can afford, it’s important to know what your limit is. That way, you won’t waste time looking at houses outside your budget ― and you won’t miss out on homes you didn’t realize you could afford.
Debt-to-Income Ratios
In order to determine how much house you can afford, you will need to understand the concept of “debt-to-income ratios.” These ratios compare your monthly income to your monthly debt, which helps lenders measure your financial strength. It also prevents borrowers from getting a home they cannot afford. There are two standard ratios: the “front-end ratio” and the “back-end ratio.” Both ratios are based on your gross income, which is income before taxes (including wages, salaries, self-employment income, pensions, and child support and alimony payments).
The front-end ratio, also known as the “housing expense ratio,” is used to show how much of your income would go towards paying the mortgage. It compares basic monthly housing costs to monthly gross income. Housing costs include mortgage payments (principal and interest), insurance (mortgage insurance and homeowners insurance), and real estate taxes. As a general rule of thumb, your monthly housing costs should not exceed 28% of your monthly income. To calculate the front-end ratio, your total monthly housing costs are divided by your monthly gross income:
- Monthly Housing Expenses ÷ Monthly Gross Income = Front-End Ratio
If you don’t know what the monthly housing expenses are, you can flip the equation to determine the maximum amount you can spend on monthly housing costs. To do this, multiply your monthly gross income by 28%. The result is your maximum housing expense ratio:
- Monthly Gross Income × 0.28 = Maximum Housing Expense Ratio
The back-end ratio is often called the “total debt-to-income ratio,” or the “total obligations-to-income ratio.” It is used to show how much of your gross income would go toward all your debt obligations. Debt obligations include your housing costs, plus any car loans, student loans, credit card balances, child support, alimony, and condo fees. As a general rule of thumb, your total monthly debt obligations should not exceed 36% of your gross income. To calculate the back-end ratio, your total amount of monthly debt is divided by your monthly gross income:
- Total Monthly Debt ÷ Monthly Gross Income = Back-End Ratio
To determine the maximum amount of debt payments you can afford each month, multiply your monthly gross income by 36%. The result is your maximum allowable debt-to-income ratio:
- Monthly Gross Income × 0.36 = Maximum Allowable Debt-to-Income Ratio
You can also compute your debt-to-income ratios by using the “How Much House Can I Afford?” Mortgage Calculator (see below).
Up-Front Costs
The down payment is the first lump sum of money you will pledge to your house. It is also a key factor in determining how much house you can afford. Most loans require a down payment of 3.5% to 20% of the home’s purchase price. In general, the bigger your down payment is, the lower your monthly mortgage payments will be. 20% down will usually get you the best mortgage rate and a more expensive house. You can still secure a loan for less than 20% down, but the interest rates will be higher and you’ll probably have to buy mortgage insurance.
Closing costs can amount to 3%-5% of the home’s purchase price. They may include lender fees, discount points, and prepaid interest. The money for closing costs will ideally come from your savings, though in some cases, closing costs may be paid by the seller or rolled into your loan.
Miscellaneous costs can add another $200-$800 to your bill. They can include a loan application fee, credit check fee, home inspection fee, or an appraisal fee. Some of these expenses may or may not be included in the closing costs.
Monthly Payments
The monthly mortgage payment consists of principal plus interest charged by your lender. The term “principal” refers to the actual amount of money you are borrowing. If you’re approved for a $150,000 mortgage, you will owe the lender $150,000 in principal. You will also be charged “interest” on that principal. How much interest you owe will depend on the amount of the principal, your strength as a borrower, as well as the type of loan and the length of the loan.
Taxes and insurance are considered part of your monthly housing expenses (front-end ratio) and include property taxes, mortgage insurance, and homeowners insurance. Property tax is an “ad valorem” tax, meaning that property is taxed “according to value” ― most property taxes are enforced locally by counties, cities, or special districts. Mortgage insurance protects the lender in case you fail to make the mortgage payments and may cost 0.5%-1% of the total loan amount, which is added to your mortgage payments for the year. In order to get a mortgage, you must also get homeowners insurance ― you can ask an insurance company/agent for an estimate.
Use a Mortgage Calculator to Find out How Much House You Can Afford
The “How Much House Can I Afford?” Mortgage Calculator will help you determine the mortgage amount you may qualify for, as well as the maximum home price you can afford. There are 3 parts to this mortgage calculator: Income and Debt Obligations, New Loan Assumptions, and the Results.
To use the mortgage calculator, begin by entering your information on the “Income and Debt Obligations” page. This includes all your monthly debt obligations (back-end ratio) such as credit card payments, car payments, child support, etc. Click “Next.”
The second part of the mortgage calculator is called “New Loan Assumptions.” This is where you provide information about the loan ― including the interest rate, length, down payment amount, property taxes, and homeowners insurance. Click “Calculate.”
The last part of this mortgage calculator is the “Results” page. It displays your front-end ratio and back-end ratio, as well as your maximum allowable payment and the home value you can afford.
Keep in mind that the “How Much House Can I Afford?” mortgage calculator estimates the loan amount you may be able to obtain ― a mortgage lender may come up with slightly different numbers. The main concern for lenders is your ability to repay the mortgage loan. They will look at your monthly income, your credit history, and how much cash you have for a down payment. Your borrowing power increases substantially if you can offer a large down payment, and you have no debt and good credit.
It is recommended that you arrange your financing before you actually start looking for a house. Most lenders will pre-qualify or pre-approve you for a certain amount. This will give you a more accurate idea of how much house you can afford. It also makes you a more attractive buyer and gives you some negotiating power – nobody wants a deal ruined because of a financing problem.
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