Buying a new home is exciting, whether you’re a first time buyer or an experienced homeowner who’s planning on upsizing or downsizing. As you start to drive neighborhoods and peruse listings, you may be wondering exactly what you can afford to pay for a home. Ask yourself the question: “How much house can I afford?” and take the time to thoroughly investigate the answer.
It’s important to know exactly how much house you can afford before you start the shopping process. Otherwise, you could find yourself roped into a home purchase that’s well out of your budget. By taking some time to calculate your budget, you can ensure you get the nicest house possible while avoiding going house rich, pocket poor.
How much house can I afford?
To understand how much house you can afford, you need to take into account two important factors — what lenders will approve you for and what fits within your budget. The good news is that these budgetary guidelines typically line up. Even so, you will need to make sure you don’t take on more house than you can afford just because the lender is willing to approve a loan for that amount.
Lenders look at a long list of criteria to determine the amount of house they’re willing to approve you for. The list includes things like your current monthly debt payments, your total debt, your income, your credit score, your current assets, how much of a down payment you can make and the current status of the economy.
1. The 5 Cs of lending
According to Wells Fargo, lender approval can be summarized as the five Cs — credit history, capacity, collateral, capital and conditions.
Credit history is your credit score and your past borrowing history can be found in your credit report. Capacity refers to what you can afford. Often, this is a look at your debt-to-income ratio — how much you are paying in debt monthly versus how much income you are bringing in.
Collateral in a home purchase will be the physical home you are buying, which becomes collateral the bank or lender can seize when you don’t repay your loan. Capital deals with what other assets you might have to help with repayment of the loan, and conditions are the purpose of the loan, the market environment and the status of the economy.
2. The rule of 20
A rule that may be somewhat antiquated — but is still widely cited as important — is the rule of 20. According to this rule, homebuyers should not purchase a home unless they are prepared to make a 20% down payment on top of the additional costs associated with purchasing the home. For example, if you are looking to buy a $300,000 home, under this rule, you should be prepared to make a down payment of $60,000.
However, this rule is rarely the case these days. According to the 2019 National Realtors Association Report, 86% of homebuyers financed their home purchase, and the average down payment was 12%. For first-time home buyers, 94% financed the purchase, and the average down payment was 6%.
The reality is that you’ll often get a better interest rate and be in a much stronger financial position if you’re able to put 20% down on a home purchase. Is it completely necessary? 86% of homebuyers don’t think so. You’ll need to assess your unique financial situation to see if the rule is fully applicable.
3. The rule of 28/36
With the rule of 28/36, prospective home buyers compare their gross income with their expected house payment and other debt responsibilities. Under this rule, no one should purchase a home where their housing expense would be more than 28% of their monthly gross income. As a reminder, gross income is the amount you make before taxes.
Note: the rule mentions housing expenses and not just your mortgage payment. This would include things like property taxes, homeowner’s insurance, homeowner’s association fees and community development fees. It does not include things like utilities.
For example, if you bring home $5,000 in income a month before taxes, the total of your mortgage payment and other housing expenses outlined above should not be over $1,400.
The second half of this rule looks at your total debt responsibilities you’ll owe for the month, including the cost of the new purchase. The total amount of these monthly payments should not exceed 36% of your monthly gross income. This should include expenses like credit card bills, student loan payments, car payments and any other form of regular debt payment you are obligated to make.
How to calculate your home budget based on income
A popular way of answering the question, “How much mortgage can I afford?” is to look at it as a percentage of your income. This method is quite similar to the first half of the 28/36 rule, but it does not include additional housing expenses.
Step 1: Add up your total monthly income
Add up all of your different sources of monthly income. This includes your paycheck, your significant other’s paycheck (if you have one and they contribute to your household, that is) and any side hustle money that you’re earning on a regular basis. Calculate this number without including taxes or other deductions taken from your check.
Step 2: Multiply that number by 25%
Once you’ve calculated your total gross monthly income, multiply that number by 25% or 0.25.
Step 3: Use this as a guideline when shopping homes
The number you get from this calculation should be the maximum you spend on your monthly mortgage payment. It’s important to note, though, that this does not mean it’s the amount you must spend. It’s completely acceptable to spend under this amount.
The hidden costs of buying a home
It’s easy to overlook many elements of the home buying process and think the only cost of buying a home is your mortgage payment. These hidden costs need to be calculated into your budget too, or you may find yourself short on cash in a situation where you thought you were okay.
These hidden costs include things like homeowner’s association (HOA) dues, community development fees charged by the neighborhood, homeowner’s insurance premiums, moving costs, closing costs, landscaping costs and property taxes.
Tips for affording a more expensive house
The rules laid out for determining how much mortgage you can afford do have some wiggle room. If you’re able to make some small adjustments to the process, you may be able to effectively afford a more expensive house.
1. Save for a larger down payment
Your mortgage payment is based on the size of your loan, not the value of your house. By saving for a larger down payment, you can lower the size of your loan, which will lower your monthly payments, total interest and overall financial obligation. This may require you to wait a bit longer to purchase a home, but it can enable you to afford a more expensive home if that’s your goal.
2. Increase your credit score
One of the five C’s of lending is credit history. Lenders are more likely to extend large amounts of credit to a borrower with a more proven history of good borrowing behaviors. Plus, by working to improve your credit score, you may be able to get a lower interest rate, which will in turn increase what you can afford to spend on a home.
3. Opt for a wider search area
If you’re trying to find a way to afford a more expensive home, you’re likely more concerned about getting more house rather than just buying a house with a higher price tag. If you’re willing to widen your search area and your search criteria to areas outside of your initial search, you may unlock the ability to get more bang for your buck. This will be heavily dependent on the area you’re in and what the deal-breakers are — things like schools, prime residential areas and proximity to work or play.
The bottom line
Taking the time to determine how much house you can afford is a prudent step in the home-buying process. It can save you time and energy by letting you know what you’re likely to be approved for by a lender. Additionally, it can help to protect you from purchasing a house you can’t afford just because you got approval for a larger than expected mortgage.
Figuring out how much house you can afford is an important first step in buying a home. We’ll show you how to calculate your budget, along with the general rules for deciding how much home mortgage you can afford.