I often receive emails from readers concerning whether or not the sender can afford a particular house – or how much house they can afford. The stories vary a lot in detail – some people have a down payment, while others do not, and some people have other debts, while others are debt free.
Regardless of the situation, though, I give these people the same advice. Your total debt payment for a given month should not exceed 30% of your take-home pay.
In other words, if you bring home $4,000 per month, your total debt payments for that month — including student loans, car payments, credit card bills, and your potential mortgage itself — shouldn’t exceed $1,200.
Now, that’s not necessarily what a bank thinks you can afford — lenders are often willing to stretch you farther than might be wise. We’ll get to that in a moment.
First, let’s walk through a few of the specifics of my 30% rule.
This is take-home pay, not gross pay. The only pre-tax number you might consider including is your 401(k) contributions, but I wouldn’t include those. I would never include taxes or other payroll deductions when thinking about this. Why? In the end, this is all about budgeting, and having 30% of your monthly income go straight into debt payments is a pretty hefty chunk of your money. This leaves the rest to cover all of your utilities, food, household supplies, gas, insurance, and other living expenses.
The percentage should be pretty close to that even if you’re earning a lot of money. Again, why? This is all about downside. You don’t want to have to sell your home in a panic if you lose your job or some other major lifestyle change occurs. You want to keep yourself afloat no matter where your ship goes.
Sticking with this policy usually implies a few things.
First, you’re going to be able to afford a bigger home if you’re otherwise debt-free. If you’re still paying hundreds per month in student loans or car loans, the burdens of home ownership are going to be intense. If you want a home in the next several years, focus hard on freeing yourself from that debt.
Second, you’re usually better off if you buy a smaller home rather than a larger one. Once you get beyond a certain point of home size, the excess space mostly just serves as storage for your excess stuff – mostly stuff you don’t really need in the first place.
When Sarah and I were house-hunting, we fell in love with a house that was about 50% larger than the one we ended up purchasing. We both just loved this house. We tried to find a way to afford it but, when we sat down and were realistic with our financial situation, we knew we couldn’t really afford it. We bought a smaller house, one within the range of what we could afford.
Guess what? We’ve never missed the extra space. In fact, as we’ve been designing our “dream home,” it’s not much bigger than the one we have now. It’s mostly just rearranged.
Third, overburdening your short-term future with expenses is a huge mistake. When you sign up for a mortgage, you’re signing up for a pretty hefty addition to your monthly pile of bills. However, when you initially sign up for them, those bills are likely within your ability to pay them each month.
The catch comes if something changes in your life. A job loss or a serious accident can derail lots of things in your life – and the last thing you need on top of those misfortunes is a difficult decision about your house when you’re unable to pay for it. It’s not worth it.
Finally, a full down payment is a tremendous help here. Not only does it reduce the size of your mortgage by up to 20% or more, it will also likely reduce your interest rate.
If you charge ahead without a full down payment — many first-time home buyer programs allow you to make down payments as low as 3.5%, and VA mortgages offer no down payment at all — you’ll be financing that much more of the home price, adding to your monthly bill, and it will typically be at a higher interest rate. You’ll also probably have to pay private mortgage insurance, or PMI, to protect the lender — which amounts to another monthly bill you won’t have to pay if you simply saved up a full down payment first.
Yes, saving $40,000 for a down payment on a $200,000 home seems difficult — especially when you’re ready to buy a home now and feel like the homes near you are climbing out of your price range — but it’s the right approach for the long term. After all, if you find it difficult to save a healthy chunk of your income each month, how will you be able to survive as a homeowner? Owning a home comes with many new expenses and responsibilities you’ll need to save for.
Given these factors, I strongly feel that a conservative approach to the question of “How much house can I afford?” is the right one.
How Big of a Mortgage Will I Qualify For?
However, how much house you can actually afford and how much a bank thinks you can afford are quite often very different numbers. Here are the key factors lenders take into consideration when determining how big a mortgage you’ll qualify for and how much house you can afford.
Your debt-to-income ratio: This is the big one. In general, most lenders want your overall debt payments — including your mortgage — to represent no more than 36% of your gross income (not take-home pay) each month.
That means a couple earning $6,000 a month can have no more than $2,160 in total debt payments. So if they have $500 in monthly student loan bills, $100 in minimum credit card payments, and a $400 monthly car payment, they won’t qualify for a mortgage that’s more than $1,160 a month.
Now remember — that’s only what the bank deems reasonable. If your gross income is $6,000 a month, you’re probably taking home something closer to $4,000 a month after taxes and other payroll deductions. If $2,160 of that is going toward a mortgage and other debts, you’re left with less than half of your take-home pay to cover all other expenses. That leaves you walking a very tight rope and it’s not something I’d recommend, even if the bank thinks it’s fine.
Your credit score: A good credit history and score will help you get a more favorable interest rate, which in turn means you can take out a larger loan without raising your monthly mortgage payment. To get the enticingly low rates that lenders advertise, you’ll need very good to excellent credit – typically a score in the high 700s or 800s.
You can use the home affordability calculator below to see just how much difference even one percentage point makes when it comes to how much house you can afford. A family earning $72,000 a year with no other debt and a $40,000 down payment saved up could afford a $379,000 house at a 4% fixed rate, according to the calculator. But that same family, paying a 5% rate because of less-than-perfect credit, could only afford a house priced at $354,000 — a $25,000 difference.
- Related: What Is a Good Credit Score?
Your down payment: By default, the more money you put down, the less you’ll have to finance. But a larger down payment — at least 20% of the home’s value — also makes your loan less risky to the lender in the event that you default on your mortgage, so it can help you get a lower rate and better terms and avoid paying private mortgage insurance.
Funds available: In addition to your down payment, a lender will look at all of your savings and investments — including your savings accounts but also any IRA or 401(k) balances – to make sure you can cover closing costs and could pay your mortgage for a few months if you were to lose your job.
Calculator: How Much Home Can I Afford?
Use this calculator to determine how much house you can afford given your income and monthly debt obligations. Click on the advanced tab, and you can adjust variables like interest rates or your preferred debt-to-income ratio — whether it’s the 36% limit most banks like to see, or a more conservative 25% to 30%.
How to Afford a More Expensive Home
Of course, it’s a lot easier to purchase a home in your price range in areas where the housing market is more in line with typical incomes. In certain parts of the country — particularly coastal cities like San Francisco, Los Angeles, San Diego, New York, Boston, and Seattle — home prices are out of reach for many middle-income earners. And yet, rents in these areas are often just as high, putting residents in a bind.
The National Association of Realtors tracks the median sale prices of single family homes by metropolitan area, and compares them to local median household incomes to create a quarterly Home Affordability Index. According to recent data, here are the least affordable metro areas in the country when it comes to buying a home (a score of 100 means the median income is just enough to qualify for a mortgage on a median-priced house).
Least Affordable Cities for Home Ownership
Median Sales Price, 2015
NAR Affordability Index
|San Jose, Calif.||$950,400||63.9|
|White Plains, N.Y.||$475,900||84.4|
|Cape Cod, Mass.||$362,600||138.1|
|Long Island, N.Y.||$422,700||141.8|
Home buyers in these areas may feel more obligated to stretch themselves, especially when rents are already oppressively high. The New York Times has a pretty comprehensive rent-versus-buy calculator, with a number of adjustable inputs to help you evaluate whether it makes sense to continue renting or to buy a home given the variables of your own situation and locality.
Four Ways to Afford a Pricier Home
If you’re struggling to afford a home in your area, don’t over-extend yourself — better to buy a cheaper home or continue renting than to stretch yourself so thin you default on your mortgage or other obligations. Here are some sensible strategies you can employ to afford a more expensive home without putting yourself in a financially precarious situation:
Save up a bigger down payment: A larger down payment can help you in so many ways — you’ll probably get a lower interest rate, you’ll avoid paying PMI, and by definition you won’t need to finance as much of the purchase, so you’ll get more house for the mortgage. If you’re priced out of homes in your area, don’t kill yourself chasing the market — just keep socking away more money for a down payment until you can reasonably afford the home you want. If you can only feasibly handle a $200,000 mortgage, but want to buy a $300,000 home — keep saving until you’ve got $100,000 to put down.
Pay down debts: The fewer debts you have, the more a bank will be willing to lend you. So if you want to qualify for a larger mortgage, pay off all your credit cards before you apply. Pay off your car. Pay down your student loans. In the example above, the couple earning $6,000 a month could only qualify for a $1,160 mortgage because of their existing debts. Without those monthly obligations, however, a bank might allow them to take out a mortgage equivalent to 25% of their income or more.
Improve your credit score: Building good credit takes time, but you can make substantial progress in less than a year if you’re diligent about paying your bills religiously and reducing your credit utilization (how much of your credit limit you’ve used up). A better score will get you a better interest rate on your mortgage, which can help you borrow more money with the same monthly payment.
Increase your income: And of course, perhaps the simplest way to afford more home is to earn more money. Whether it means taking on side jobs or applying for the loan with your partner so you can combine incomes, a higher income will help you qualify for a larger mortgage.
How Much House You Can Afford? It’s Really Up to You
Remember that just because a bank says you can afford a certain mortgage doesn’t mean that it’s true. They may be comfortable lending that amount to you, but it’s more important that you are comfortable with the idea and amount of that monthly payment.