Purchasing your house is one of the biggest decisions you’ll ever make, so you want to make sure it’s a smart one. Figuring out how much house you can afford is the first step in doing just that.
There are some ballpark guidelines for figuring out home affordability. Of course, you want to weigh them against your own unique situation, but these rules can at least start you in the right direction.
THE 20 PERCENT DOWN PAYMENT RULE
One quick way to figure out how much home you can afford is to consider how much you’ve saved for a down payment. Most experts recommend putting down 20 percent. So if you have about $50,000 saved, you can afford a $250,000 home.
Of course, this is easier said than done. For most of us, 20 percent is a big chunk of change. However, putting down that amount has a number of benefits: You take out a smaller loan (so you pay less in interest), your monthly mortgage payments are lower, and you can avoid paying private mortgage insurance (PMI).
THE 2.5 TIMES YOUR INCOME RULE
Another general guideline: Your home should be no more than 2.5 times your gross income. If you earn $50,000 a year, that would mean your home affordability is $125,000.
Whereas the 20 percent down payment rule is focused on your savings, this rule is focused on another important factor: your cash flow.
THE 30 PERCENT BUDGET-BASED RULE
According to this rule, housing should make up no more than 30 percent of your gross monthly budget (some experts, it's worth stating, think the 30 percent figure is baloney, while others believe this number should be even lower, around 25 percent). However, housing costs go beyond a monthly mortgage. Don’t forget to include your insurance, property taxes, maintenance costs, and so on in your calculations. Those expenses add up quite a bit.
WHERE THESE RULES FALL SHORT
Again, these are ballpark rules, so there’s a lot they don’t consider. For example, the 20 percent rule doesn’t take your income into account at all. You may have $50,000 saved, but if you earn a low income, buying a $250,000 home probably isn’t a good idea.
On the flip side, the 2.5 times your income rule obviously considers your cash flow, but it doesn’t take into account how much you have saved or what your job stability is like. And none of these rules consider your net worth. If you’re nearing retirement, for example, and you don’t have much saved, it’s probably a better idea to focus on that.
OTHER FACTORS TO CONSIDER
For a better idea of what you can actually afford based on your own situation, you’ll want to consider the following factors:
Long-Term Cost: Many people forget to consider the massive long-term cost that comes with buying a home. The interest alone can add up to hundreds of thousands of dollars over time, not to mention the insurance, taxes, HOA fees, and other ongoing expenses. In some cases, those extra costs make renting a smarter option. The New York Times has a handy calculator that helps you weigh the long-term cost of renting against the long-term cost of buying a home to tell you at what price point buying might be the better option.
Your Own Financial Picture: Many people stretch their finances to afford a home only to find themselves “house poor” later. This basically means you have the house, but you can’t afford the rest of your living expenses. To avoid this, make sure you have a healthy savings cushion. You should have an emergency fund with at least a few months' worth of living expenses saved, and you should also be on track for retirement. This is where the 30 percent rule comes in handy, too—housing costs shouldn’t eat up the majority of your income.
Lender Criteria: Knowing how your lender decides your home affordability can give you an idea of how to make that decision for yourself. Here are a few basic factors they consider:
Debt-to-Income Ratio: This is how your monthly debt obligations and expenses compare to your monthly income—the lower, the better. Lenders don’t want the bulk of your cash tied up in addressing debt.
Credit History: If you have a solid credit score and a good history of making payments on time, that indicates you have decent financial habits, which means you’re likely to make your mortgage payments.
Down Payment: The more you put down, the higher your mortgage qualification amount. You can put down less than 20 percent, but, of course, that means you’ll take out a larger loan and you’ll have to pay PMI.
Housing Costs vs. Income: Like the 30 percent rule, lenders want to make sure your housing costs don’t overwhelm your income. If most of your income goes toward housing costs, there’s a bigger risk that you won’t be able to pay your loan if a financial emergency arises.
If there’s one thing we learned from the housing crisis, it’s to make our own decisions about how much home we can afford. So before signing on any dotted lines, do the math.