The amount of home you can afford depends on many factors including your income, credit score and lifestyle. If you know how much you can actually afford to spend on a home before you start shopping, you can enjoy less stress throughout the process.
Today, we’ll look at how you can get an understanding of these values. We’ll show you how to figure out how much debt you can handle and how to shop within your budget.
Step 1: Determine How Much Home You Can Afford
First, you need to determine how much of your monthly income you can spend on housing. You need to remember to leave yourself a reasonable cushion for savings, insurance, taxes and other expenses.
One good place to begin is by analyzing your debt-to-income (DTI) ratio. Your DTI is a numerical representation of how much you spend on recurring debts per month. Lenders look at your DTI when they consider your mortgage application to determine if you can afford to take on more debt. Knowing your DTI can help you determine how much you can afford to spend on a monthly mortgage payment. Your DTI can also help you determine if you’re ready to move from renting to buying.
Calculating your DTI is relatively simple. You only need to include regular and recurring expenses in your debt calculation. Your debt obligations might include:
- Your monthly rent
- Your monthly child support payments or alimony
- Student loan payments
- Auto loan payments
- Personal loan payments
- Minimum payments you must make on any credit cards you have
You don’t need to include things like grocery expenses, utility bills and taxes.
After you calculate your total monthly debts, divide your debt obligation by your total pretax household income. Divide by 100 and you have your DTI as a percentage.
As an example, let’s say your total monthly debts equal $2,000 and your monthly household income is $5,000 before taxes. To find your DTI, all you need to do is divide $2,000 by $5,000. In this example, your DTI is 0.40, or 40%.
Lenders don’t like loaning money to borrowers who already have a lot of debt. A high DTI means you’re less likely to pay back your loan. As a general rule, lenders like to see that you have a DTI of 50% in or less before they’ll issue you a loan.
If your DTI is greater than 50%, you’ll have a tough time finding a loan. You may want to take some time to reduce your debt before you apply for a mortgage.
If your DTI is below 50%, look at what percentage of your budget you’re currently spending on housing. As a general rule, you shouldn’t spend more than about 33% of your monthly gross income on housing.
Now that you know your DTI, you can get a good idea of how much you can afford to pay monthly for your mortgage with a few simple calculations. In the example above, we saw that your DTI was 40%. If your ratio is approaching 50% (like in this example) you’ll want to keep your housing expenses close to what you’re paying now.
Keep in mind that your rent doesn’t include other costs associated with owning a home like insurance and taxes. This means you’ll likely end up taking a premium that’s below what you’re currently paying in rent to stay at the same DTI.
If you have less debt, you can be more flexible. For example, let’s say your monthly debts equal $2,000 but your income is $8,000 gross. This puts you at a 25% DTI, which is great. In this instance you can afford to take on more debt.
Let’s say you want to keep your DTI at or below 35%. To consider how much you can afford in a mortgage premium, multiply your comfortable DTI by your gross monthly income. For example:
$8,000 × .35 = $2,800
Ideally, you’d want to spend a total of around $800 per month on your mortgage premium. This will keep you around your ideal DTI.
Step 2: Estimate Your Monthly Mortgage Payments
Now that you have a rough idea of how much you can afford to spend monthly for a mortgage premium, it’s time to figure out a budget for home shopping. To calculate your ideal home price, you must consider two factors that heavily influence how much you’ll pay for your loan: term and interest.
Your mortgage term is the total length of your mortgage. If you have a term of 30 years on your loan, it means you’ll make a premium payment every month for 30 years. After this period, your loan is fully matured and the lender closes your account. The most popular mortgage terms are 15 years and 30 years.
However, lenders can create their own custom loan offerings. At Quicken Loans® you can get a term as short as 8 years or as long as 30 years.
Taking a longer mortgage term lowers your monthly payments. This can allow you to buy a more expensive home. However, you’ll pay more for your loan over time with interest charges.
Interest payments go to your lender in exchange for giving you your loan. The specific interest rate you’ll pay depends on a number of factors including your credit score, your loan structure and current market conditions. Even a difference of a tenth of a point in interest can mean paying thousands more for your loan over time, so it’s worth the effort to shop around for a loan to get the best rate possible.
Need a little more help to figure out exactly how much you can afford to spend on a home? Rocket Mortgage®’s Mortgage Calculator helps you estimate your total mortgage and how much you can expect to pay each month. Play around with the mortgage calculator until you settle on a monthly payment that matches up with your budget.
Step 3: Factor In The Costs Of Homeownership
Your principal and your interest aren’t the only things you need to pay for when you take out a home loan. There are a few other payments to consider when you’re deciding how much you can afford to spend on a home. Some additional costs of homeownership include:
- Homeowners insurance: Unlike car insurance, homeowners insurance isn’t a legal requirement to own a home. However, most mortgage lenders won’t give you a loan unless you have adequate insurance. Homeowners insurance protects you against damage to your home from hazards like fires, break-ins and lightning storms. Your homeowners insurance rate will vary depending on your individual circumstances, but you can expect to pay about $100 per month for your premium.
- Property taxes: No matter where you live, you must pay property taxes. Property taxes go to your local government and fund things like public schools, libraries and emergency services. Your property tax rate will vary depending on where you live. If you’re shopping for a home in a specific county, know the effective tax rate to estimate your liability.
- Private mortgage insurance: If you buy a home with less than a 20% down payment you must pay private mortgage insurance (PMI). PMI is insurance that protects your lender if you default on your loan. PMI payments can add up to $100 extra to your monthly premium. However, you have the option to cancel your PMI once you reach 20% equity in your home.
- Closing costs: Closing costs are one-time expenses you pay when you close on your loan. Closing costs include things like appraisals, title insurance and attorney fees. Expect to pay between 3% – 6% of the total purchase price of the home in closing costs.
It’s also important to keep in mind that variable expenses like utilities, maintenance and repairs will also come out of your budget when you own your home.
Step 4: Compare With Your Budget
Now that you know the full cost of homeownership and you have a rough idea of how much you can afford to spend a month, take a look at your household expenses. How does your calculated mortgage premium fit into your budget? When you factor in things like homeowners insurance and property taxes, how does your DTI change?
Before you commit to a mortgage, you need to be absolutely sure you can make your premium, insurance and tax payments.
If you don’t already have a household budget, track your expenses for a few months and see where your money is going. Look at the amount of money you have coming in and compare it to what you currently pay for housing with the full costs of homeownership. As a general rule, your total homeownership expenses shouldn’t take up more than 33% of your total monthly budget.
If your anticipated homeownership expenses take up more than 33% of your monthly budget, you'll need to adjust your mortgage choice. Taking a longer mortgage term and buying a less expensive home are both ways you can lower your monthly payment.
The amount you can afford to spend on a home depends on a wide array of factors. First, you should calculate your DTI by comparing your current debts to your income. This will allow you to anticipate how much you can afford to take out in a loan.
Rocket Mortgage®’s Mortgage Calculator can help you anticipate how your interest and loan term might change your payments. You also need to factor in additional homeownership expenses like insurance, taxes and maintenance costs.
Once you have a rough idea of how much home you can afford, compare it to your current household budget. If you don’t have a budget, track your household spending for a few months. Look at how a mortgage payment would affect your savings, income and DTI. If it seems reasonable, you might be ready to get a loan. If it doesn’t seem reasonable, you should reconsider how much home you can really afford.
Remember, everyone’s financial situation is different and it’s best to speak with a licensed financial expert or advisor before making any major financial decisions.
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