How Much House Can I Afford? Read This Guide

In the past year, mortgage rates have hit historic lows, causing a flurry of activity as homeowners look into refinancing options and first-time homebuyers look into purchasing a new home. While interest rates are making 2021 an ideal time to get into the market, with such a large purchase it’s critical that you don’t bite off more than you can chew.

Current shoppers (myself included) remember the stock market crash of 2008 well, and the role mortgage-backed securities played in that is likely to give anyone pause as they start to calculate whether or not homeownership is truly within reach. The last thing borrowers want to have to face is getting caught up in another housing bubble.

With all of that said, how can you best go about assessing your financial situation to see whether or not a mortgage is in the cards—as well as how much house you can truly afford?

Using a home affordability calculator is a great way to start to get a rough estimate of where you stand; however, with the housing market as competitive as it currently is, it’s a better idea to get a little more detailed before you start looking at places. If you’re ready to dive into the nitty-gritty and discover how much home you can truly afford, the following concepts and factors are what will play the biggest role in your journey from open house to closing.

Two of the biggest factors to weigh when it comes to determining your housing budget are your current income and what existing debts you have. Both of these factors play a major role in how mortgage companies assess how much of a loan they’re willing to give you.

When lenders seek to determine your eligibility for a specific loan amount, one of the biggest factors is your annual income. Since a traditional, 30-year mortgage is amortized over 360 months, lenders need to know that you have the monthly income to cover the costs associated with your loan as well as other living expenses.

A decent way to go about calculating what a lender may see you as able to afford each month is to take your AGI (annual gross income), divide it by 12, and then multiply it by .45, or 45%. Since most mortgage companies won’t want to saddle you with a debt-to-income ratio of more than 45%, that math will give you a good idea of the maximum amount lenders may think you’re able to afford based on your gross monthly income.

Using the above formula and 2019’s median household income in the United States of $68,703, that means that a typical household has $5,725.25 each month—about $2,500 of which could go towards a mortgage if it was that household’s only debt.

Of course, if you’re like most people, your total debt prior to taking out a mortgage isn’t $0. Some of the monthly debt payments that could impact what’s called your debt-to-income ratio include things like car payments, credit card payments, and student loans.

It’s worth noting that when mortgage companies consider these debts, they only weigh how these debts impact your monthly debt payments. That means that even if you have two car loans totaling $60,000 or a credit card with a balance of $9,000, the mortgage company will only factor in the monthly minimum payments on those debts towards your debt-to-income ratio.

Continuing with the example using data from median households in the U.S., that means that with monthly minimum payments of $400 on your student loans, $79 on your credit card, and $250 for an auto loan, the amount you could put towards a mortgage is actually $729 less. Instead of qualifying for a mortgage with a monthly payment of $2,500, your budget would actually max out at about $1,771.

Account for the costs that factor into your monthly payments When it comes to your monthly mortgage payment, there are more aspects to your mortgage payment than just the principal and interest paid back on your home loan. While lower mortgage rates mean that you can save thousands of dollars on your loan in the long run, a better interest rate from a good credit score isn’t the only piece of the puzzle when it comes to paying your mortgage.

Related: Debt to Income Ratio: What It Is & How It Affects Your Finances

The biggest component of any mortgage payment is, unsurprisingly, the purchase price. With an interest rate of 3% and a purchase price of $225,000, your monthly principal and interest would likely be about $900. Even having an offer accepted that’s only $5,000 less makes your monthly principal and interest about $20 less—which sounds like a small amount but can be a big help if your lender has pre-approved you for no more than a specific limit.

Another major aspect of your monthly mortgage payment is property taxes. Although property taxes are calculated annually, you’ll need to factor them in every month, which can impact your monthly cost considerably depending on the appraisal of your home and where you live. It may be worth getting your property taxes re-assessed if you’re looking for a way to cut down on these costs.

Homeowners’ insurance is another cost that can affect your monthly mortgage payment. Even if you’re shopping for a condominium, you’ll still need some form of homeowners insurance, generally called hazard insurance. There are a few ways to save on your homeowners' insurance, from shopping around for a different policy to bundling your insurance with an existing product like auto insurance.

While conventional wisdom states that you should put 20% down on a home when you’re purchasing, for many first-time homebuyers, saving up 20% for a down payment or putting 5% down on a home is the difference between getting their foot in the door now or never. If you put less than 20% down on a home, your lender will have you pay something called private mortgage insurance, or PMI, which effectively protects them should you default on your mortgage.

Generally, since this is money you don’t get back and isn’t applied towards the principal and interest of your home loan, it’s a bad idea to avoid costs like this. However, with mortgage rates so low and PMI generally being less than 1% of the cost of your loan, many people are buying homes with 5% or even 3.5% downpayments to get into the housing market. It’s also worth noting that some mortgage products allow you to refinance and eliminate PMI once you’ve paid 20% equity in your home.

Ultimately, PMI is a personal decision; however, in high cost of living areas like Chicago, Boston, Los Angeles, and New York City, PMI may be a necessary expense if you don’t want to be priced out by the time you’ve saved your downpayment.

If you’re shopping for a condo, townhome, or property in a gated community, you may need to also budget for homeowners association fees. An HOA generally sets forth certain rules and regulations about what you can do in your dwelling and usually costs a monthly fee. That monthly fee could go to a variety of causes, from external building maintenance and landscaping to some part of your utilities and establishing cash reserves in case of an emergency. Particularly if you’re on a tight budget, HOA fees can make or break the inventory you’re looking at, so be sure to factor them in if you’re looking to live in a condo.

Home buying is an exciting, yet complicated, process, and it’s important to wrap your head around the financial impact that housing expenses will have on your life. In addition to saving up a downpayment and covering closing costs (usually an additional 3% to 5% of the total sale), it’s important to consider the monthly impact a home will have on your finances. With a purchase as big and stressful as a home, the more information you have the better!

Once you’ve figured out what you think your budget is, it’s a good idea to reach out to a few different lenders to see if your math is on point or not. A mortgage lender can answer any additional questions you have about different loan terms, too, whether that’s a 30-year conventional loan or an FHA loan. Once you’ve shared some W2 information, pay stubs, and tax returns with your lender, they can even get you pre-qualified or pre-approved for a home in your price range, letting you shop with confidence.