How to Determine How Much House You Can Afford

Co-authored by Michael R. Lewis

Last Updated: April 10, 2020

Realtors and other financial experts regularly suggest that owning a house is a better financial decision than renting. Home ownership means that as you pay off your mortgage you build real estate equity, instead of throwing your money away in rent to build up another person's equity. When you are ready to take the plunge into buying a house, the real trick is figuring out how much home you can afford. That decision is based on your debt-to-income ratio, the down payment you can afford, and the interest rate you can get, among other factors.

Part 1

Part 1 of 3:

Determining Your Maximum Home Price

1
Get some free advice by talking with a mortgage broker. If you get a skilled broker he or she will want to make sure that you have the information you need about what kind of loan you can afford based on the bank's calculations and rules.
- A good place to look for a broker is at your local bank branch. They are often available right at the branch. If not, the branch can usually provide you with the contact information for someone they recommend.
- If you can't find a mortgage broker through your bank, ask any real estate agent or friends for referrals. It may be good to consult multiple people to make sure you are getting the best possible information.
2
Estimate the on-going, non-mortgage costs of homeownership. A homeowner must be prepared for the continuous monthly costs of utilities, continued maintenance, and liability for property taxes and insurance. Utilities, such as electricity, natural gas, water, and sewer, must be paid each month. Owning a home costs the average homeowner about $500 a month over and above the mortgage payments.^{[1]
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Go to source} Remember that these costs are median costs and can be significantly higher in different regions of the country.
- The ongoing costs can be even higher if you belong to a homeowner association or use landscaping professionals to take care of your property.
- Many financial experts recommend that you spend no more than 40% of your income on housing, including the non-mortgage costs. Assuming non-mortgage costs of $500 per month regardless of the income of the home owner, a household earning $70,000 per year could afford to pay up to $1800 per month for mortgage costs.
3
Check the home mortgage market for different programs. The mortgage market can be confusing for a first-time homebuyer due to the variety of choices. The majority of mortgages fall into three categories: FHA, VA, or conventional.
- FHA. The Federal Housing Administration guarantees lenders against losses that might result from a borrower’s default. FHA-guaranteed mortgages are available to all home buyers. Down payments can be as low as 3.5%, but borrowers who put up less than 20% of the purchase price are required to buy and maintain private mortgage insurance until their equity reaches 20% of the original purchase price.
- VA. The Veteran Administration offers government guarantees against loan defaults to lenders for military service members and veterans. The biggest advantage is that borrowers can buy a house without a downpayment. Unlike other loan types, VA- guaranteed loans do not require private mortgage insurance.
- Conventional. Unlike the other types, a conventional loan does not provide a government guarantee of repayment to the lender. As a consequence, lenders often require more stringent credit and income requirements than FHA or VA mortgages. Interest rates may be higher for less than pristine credit ratings. In addition, if the borrower makes less than a 20% down payment, the borrower must buy private mortgage insurance until the equity reaches the 20% of the original purchase price.
4
Make sure to know what kind of rates and rate programs are available to you. Long-term interest rates constantly fluctuate and significantly affect the total cost of the house and the monthly payments. In addition, borrowers may have a choice between a fixed rate mortgage and an adjustable rate mortgage, although there has been a recent crack down on predatory adjustable rate mortgages.
- Fixed rate mortgages. The interest rate will stay the same for the entire term of the loan, so the monthly payment will not vary. A flurry of refinancing activity always accompanies any significant decline in long-term interest rates as borrowers seek the lowest possible costs.
- Adjustable rate mortgages. Often referred to as “ARMs, the interest rate adjusts from time to time according to the terms of the mortgage. The adjustment period may be one year or greater. A hybrid ARM loan is one that remains fixed for a stated period of time, then adjusts annually. While ARMs typically have lower interest rates initially than fixed-rate mortgages, the risk of higher interest rates in the future is always present.
- Finally, borrowers can choose the term of their mortgages. The 30-year fixed-rate is the predominant choice of most home buyers, accounting for 90% of home mortgages in the first half of 2013. However, some buyers opt for 15-year terms since interest rates are typically 1.0-1.5% lower than 30-year mortgages even though monthly payments are higher due to the faster payoff.
5
Remember that there will be additional one-time costs associated with your purchase. Buying a home requires the payment of loan closing costs such as a fee for running your credit report, attorney’s fees, and title insurance. On average, buyers pay approximately $3,700 in closing costs. Some closing costs might be included in the down payment or in the long-term mortgage loan.
- In some cases, buyers negotiate for sellers of the home to pay a portion of the costs. Be sure you understand the amount of closing costs that will be charged to you and how they will be paid before closing the loan.
- In order to figure out how much you can spend on a house you need to take into consideration that you cannot spend every cent you have on a down payment. Closing costs and a variety of other expenses, such as moving expenses or renovation expenses, will significantly increase the amount of money you need to spend right away.
6
Check your credit score. Your credit score will be one determining factor in how much you can borrow to buy a house and what kind of rate you can get on your loan. If the bank or other financial institution you are attempting to borrow from does not like your credit score, they may reject your application altogether.
- For instance, to qualify for a FHA loan with a down payment of only 3.5%, you must have a minimum FICO credit score of 580. Applicants with a lower score will be required to make a downpayment of 10% to qualify for a FHA loan.
- If you anticipate buying a home within the next two years, begin immediately to improve your credit score. Improving your credit score will get you a better mortgage rate, thus potentially saving you thousands of dollars in the long run, which will be reflected in a lower mortgage payment each month.
7
Determine your maximum down payment. Depending upon your credit score and the type of loan for which you qualify, you will be asked to make a down payment of between 0% and 20% of the home's selling price. Buyers who can make down payments of 20% or more of the home price have a greater chance of being approved for lower rate, less expensive mortgages.
- In the U.S., making a down payment of at least 20% of the purchase price of a home will allow the buyer to avoid the cost of private mortgage insurance. PMI is not a huge expense, usually between $30-$70 every month for every $100,000 you borrow, but avoiding the monthly premium is worthwhile, as it will save you a significant amount of money over the long term.^{[2]
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- Many young people rely upon savings and help from their families in order to buy their first home. Coming up with a large amount of cash can be difficult for anyone, so planning and saving your money will be important leading up to a house purchase.
- Some first-time home buyers borrow from their 401(k) plan to make a down payment, paying themselves back over a period of years. Be aware that if you leave your employer before repaying the loan, you may be subject to income tax and penalties on the unpaid 401(k) loan balance. First-time home buyers can also withdraw up to $10,000 from their IRAs for a down payment without penalty. Income tax will be due on the withdrawn amount and the funds must be used within 120 days for the purchase of a home.
8
Figure out your debt ratios. Mortgage lenders are primarily concerned with a borrower’s ability to repay the loan since the process and procedures to foreclose upon a home, sell the property, and seek redress from the borrower are expensive and time-consuming. Mortgage lenders are primarily concerned about two debt-to-income ratios: front-end ratio and back-end ratio.
- Front-end ratio. Under FHA guidelines, the monthly mortgage payment (principal, interest, taxes, home insurance, and PMI if applicable) should not exceed 29% of gross monthly income. The ratio is calculated by multiplying your annual salary by 29% and dividing the result by 12. For example, Joe earns $60,000 annually and has a front-end ratio of $1450 (($60,000 x .29)/12).
- Back-end ratio. The back-end ratio calculates how much of your gross income goes to debt repayment each month. Debt includes all debt - the mortgage, car loans, credit cards, student loans. FHA guidelines repayments of debts with more than 9 months remaining term should not exceed 41% of your income. To calculate your back-end ratio, multiply your gross annual income by 41% and divide the product by 12. In Joe’s case, his total debt repayment should not exceed $2050 per month (($60,000 x .41)/12).
- If you are attempting to get a VA loan, remember that the VA does not consider the front-end ratio, only the back-end ratio. Veterans who exceed the ratio may still qualify for a mortgage-guaranteed loan, but must meet higher income standards.
- Conventional mortgage lenders also use debt-to-income ratios to qualify potential buyers. Since there is no government guarantee in the event of default, the desired ratios’ standard are more stringent than VA or FHA standards: 28% for the the front-end ratio and 36% for the back-end ratio.
9
Calculate your maximum home purchase price. Now that you understand all of the costs associated with purchasing a house, you can figure out what the actual one-time and monthly costs will be for a specific purchase price. The price of a home you can comfortably afford depends on your down payment, closing costs, the mortgage loan amount, the term of your mortgage loan, and the interest rate that will be charged on the loan balance. Also keep in mind that you will need to keep a bit of money on hand for the variety of costs that will come up when you actually move into your new home.
- While you could develop your own spreadsheet to make these calculations, there are a plethora of mortgage loan calculators on the Internet that allow you to quickly change variables to see how each element is affected. For example, a $240,000 home purchase with an FHA-guaranteed fixed-rate mortgage at 4.5% would require a downpayment of $20,000 and payments of $1,013.37 for thirty years. The same mortgage with a 15 year term and a rate of 3.5% would require payments of $1,429.77. By contrast, a $240,000 home purchase with a VA-guaranteed fixed-rate mortgage at 4.5% would require no down payment and payments of $1,216.04 for thirty years. The same mortgage with a 15 year term and a rate of 3.5% would require payments of $1,715.72.
10
Decide on your "comfort zone." Just because the math may say you can afford a specific purchase price, doesn't mean you have to buy a house that expensive. Think about how you would feel each month paying the maximum you can afford. Would you feel constantly stressed? Before you start seriously looking at homes, figure out how much you would be comfortable paying each month. This might be less than the lender feels you can afford.
- If you decide, for example, that you don’t want to pay more than $900 per month, you may need to look for a less expensive home than you could qualify for, or you could offer to make a larger down payment than the lender requires, thus lowering your monthly payments.
11
Seek pre-approval for a mortgage loan. It is worthwhile to seek a mortgage pre-approval before embarking on a home buying expedition. The pre-approval is a letter from a lender that you are preliminarily approved for a specific loan amount under the lender’s guidelines. The information can help you determine the appropriate home price range you can comfortably afford.
- In addition, some sellers may require a re-approval letter before accepting an offer to buy their houses.
- A pre-approval letter is not an offer to lend, a commitment to make a loan, or a guarantee of specific rates or terms. Furthermore, having a pre-approval letter does not guarantee that an offer you make on a home will be accepted by a seller.
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Part 2

Part 2 of 3:

Considering All Aspects of Home Ownership

1
Decide whether you are ready to settle down in one place. You will need to balance the potential financial benefits of home ownership with the other factors of your life. A home can be a welcome haven to recharge your batteries or an anchor that locks you down and limits your options. Owning a home is more restrictive than leasing or renting a place to live. Selling a home might take months, or years, of effort to get the price you want. On the other hand, renters can pack up and move across town, the country, or the world fairly quickly by settling the terms of their lease agreement.
- Have you considered the possibility that you or your spouse may be transferred to a new location within the next few years? Many experts suggest that if you don’t plan to stay in house for at least three years, buying a home makes no sense.
- Does your lifestyle conflict with the requirements of owning a home such as weekly lawn care, seasonal cleaning of gutters, or installing shutters? While most of the work of homeownership can be delegated to others for a price, that simply adds onto the on-going cost.
- Consider the likelihood that your marital, health, or career status may change within the next few years. How will owning a house affect your options to adjust?
Thousands and thousands of homeowners have learned to their dismay that the prices of homes, like other assets, can drop in value, leaving the owners with mortgages greater than the value of the property. Foreclosures exploded across the country after 2009 and abandoned homes have driven down the value of surrounding properties.
3
Recognize the social pressure of home ownership. Keeping up with the Jones' is an ever-present danger in most neighborhoods and few are able to resist the competition. The larger the home, the more space to fill up and the greater pressure to buy things. The hand-me-down furniture with your frat-house bookcases looked great in an apartment, but not as good when compared to the neighbor’s furnishings. The combination of empty space and spending time in neighbor's wonderful homes can ruin many a carefully planned budget.
- If you do buy a house, keep your budget on track by remembering that nostalgia is in fashion. Don’t be afraid to check thrift and consignment stores for used furniture. It is surprising how a little elbow grease and paint turns a throw-away into a treasure.
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Part 3

Part 3 of 3:

Identifying Your Housing Needs

1
Calculate how much living space you need. What is too much and what is too little space? There are no guidelines for figuring this out, as it's largely a matter of personal opinion. Some families prefer small bedrooms and larger living areas to promote togetherness; other families value privacy so bedrooms are bigger and living areas are smaller. Whatever your need, there is a home that will fit those needs.
- When considering your dream house, think of the rooms you need first, then their desired sizes. For example, do you need three bedrooms or five? Is a formal dining room important? Will a living area-what people used to call a “den”-replace a formal living room? How many bathrooms will be needed? Do you want a separate laundry room? Do you want a multi-story or a ranch?
2
Consider changes to your family in the near future. The typical homeowner keeps his or her house for nine years before selling.^{[3]
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Research source} Almost 1 in 4 homeowners sell their homes within five years of purchasing. One of the primary reasons for selling one home and buying another is a change in family size (children) or family activities. A typical family might buy a smaller first home (1000-1400 sq ft), upsize as children come along and grow up (1,800-? sq ft) and downsize (1000-1400 sq ft) when the children leave home.
- Also think about the educational requirements of your family. Home prices vary considerably from one neighborhood to the next, often based upon public perceptions about the school system. Do you have or expect to have children while living in the home? Will your children attend public, private, or parochial schools? Many home purchasers are willing to pay more for a house in a good school district because it will eliminate the expense of private school tuition and fees. On the other hand, a single person or pair of adults without children may decide that the premium for a good school system is too high.
- This does not mean that you have to buy a house that is the right size for your future family, and too big for you now. The typical homeowner keeps his or her house for nine years before selling.^{[4]
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  Research source} Almost 1 in 4 homeowners sell their homes within five years of purchasing. One of the primary reasons for selling one home and buying another is a change in family size (children) or family activities. A typical family might buy a smaller first home (1000-1400 sq ft), upsize as children come along and grow up (1,800-? sq ft) and downsize (1000-1400 sq ft) when the children leave home.
Consider your commute time and the costs it will entail. An extended distance between home and work is likely to mean you will spend more time on mass transportation or in your car. Weigh how distance to work will affect your life, financially and otherwise, when deciding on your ideal location.

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