Are you familiar with the concept of being house poor? It basically means that you overextend yourself with monthly mortgage payments, spending so much money on your residence that you have very little left over for other things.
This is obviously not a desirable outcome, and the good news is that it’s avoidable. To avoid becoming house poor, you’ll need to do some careful budgeting on the front end, assessing how much home you can afford before you take out a loan or sign a contract for a house.
So how much home can you afford? In this post, we’ll share some basic calculations you can make to ensure a financially sound real estate decision.
How to Determine How Much You Can Afford
Early in your real estate journey, there are a couple of numbers you should track down to help you assess how much home you can afford. These numbers are your debt-to-income ratio and your credit score. Make sure you have these numbers in hand before you even start looking at houses, as they will help you determine which houses you should be considering.
Based on Debt-to-Income Ratio
First, calculate your debt-to-income ratio. This number is a comparison of how much money you make each month versus how much money you owe. More precisely, it represents the percentage of your gross monthly income that goes to things like rent, credit card debt, student loan debt, etc.
To determine your debt-to-income ratio, simply add up all of your monthly debts, then divide that number by your gross monthly income (that is, your income before taxes).
The lower your debt-to-income ratio, the less risky you’ll be to lenders… and thus, the better terms you’re likely to get on a mortgage loan. As a general rule, you want your debt-to-income ratio to be lower than 50 percent; if it’s more than that, you probably aren’t ready to purchase a house.
Based on Credit Score
Another way to determine how much home you can afford is to check your credit score. This number will be somewhere between a 300 and an 850; the higher the number, the better your credit, and the less risky you’ll appear to lenders.
Most mortgage experts say that a score of 620 is good enough to qualify for a decent loan, while anything above a 720 is really good, and suggests that you can get really optimal terms for your home loan.
If your credit score is too low, don’t panic. Instead, wait a little while before pursuing a real estate purchase, and take some simple steps to improve your score. Pay off debts, be on-time with your monthly bill payments, and avoid opening any new lines of credit, including credit cards.
How Much of a Down Payment Should You Pay?
If you’re asking, “what home can I afford,” calculating your debt-to-income and tracking down your credit score are essential steps. However, you’ll also want to make sure you have enough cash on hand to make a down payment.
How much should your down payment be? Ideally, 20 percent of the total cost of your home purchase.
If you can’t afford a 20 percent down payment, that’s not necessarily a deal breaker. However, many conventional lenders will require you to purchase private mortgage insurance (PMI), which will add to the cost of your monthly house payments. That’s something to keep in mind as you think about your real estate budget.
How Much Savings Should You Have?
Before you start looking at houses, it’s wise to verify that you have some money in your savings account, or some other liquid asset you can use to make your down payment. But it’s not just the down payment you need to worry about. Also ensure that you have enough cash on hand to cover closing costs, such as the home inspection and real estate agent’s fees. Depending on your situation, this may encompass anywhere from three to seven percent of the total purchase price.
Ideally, your savings will provide you with enough money for that 20 percent down payment and the closing costs, though closing costs may also be rolled into your monthly mortgage payments.
How Much Should the Monthly Payment Be?
As a rule of thumb, you’ll want to ensure that your monthly house payments do not exceed 28 percent of your gross monthly income.
Note that these monthly house payments include not just your mortgage principal and interest, but also things like property taxes and homeowners insurance, which all tend to be rolled together into one payment.
Compliance with the so-called “28 Percent Rule” is a good way to minimize your risk of becoming house poor.
Looking for the Right Mortgage Loan
Once you account for all of these financial considerations, seek pre-approval for a mortgage loan. Your pre-approval letter will tell you exactly how much of a loan your mortgage company is willing to approve, which in turn shows you how much house you can afford.
Indeed, raising the question of “what home can I afford” is an important step for any buyer. Use our tips to answer this question in an informed, responsible way. And if you have any questions about your real estate journey, we recommend reaching out to a mortgage professional. Talk to an expert today to find out how much house you can afford.