Are you thinking about buying a house? Homeownership can be an exciting time, but it can also bring up many important questions: What house can I afford? How big of a loan can I afford? Will I qualify for a mortgage? How much money will the lender require me to provide up-front? What if I can’t keep up with the monthly mortgage payments?
Here’s what you need to know about how much you should spend on a house.
What Can You Afford Every Month?
The first question you should be asking yourself is how much you believe you can afford to spend on a house every month based on your monthly income. This is a serious point to consider because once you lock into a 30-year mortgage, you will be committed to making this payment for a very long time.
If you’re already spending money on rent or another house, how stressed are you by the monthly payment? For example, if your costs are $1,000 per month already, how easy or difficult is it to come up with this money for housing every month?
Sit down and have an honest review of your finances. Go through your bank accounts, annual income, and credit card debt, and consider how much of your budget is genuinely leftover after monthly debt payments, food, car loan monthly payments, health insurance, housing budget, and any other unexpected expenses you already have. You could also use an app like Mint or YNAB to help categorize your spending and look for trends.
How Much Down Payment Will You Have?
In addition to how much mortgage you can afford, another critical question is how much money you’ll be able to bring to the table up-front as a down payment.
The classic, ideal down payment amount is a minimum of 20 percent of the purchase price. So, for example, if you plan to buy a house that costs $200,000, you should typically bring $40,000 with you for the down payment.
However, mortgage lenders have become more relaxed about down payments over the past few decades and will often accept less. According to the National Association of Realtors, most U.S. homebuyers put down just 12 percent when buying a house. Most conventional loans will even allow as little as 3 percent for a down payment. Even the government’s FHA (Federal Housing Administration) loan only requires 3.5 percent.
However, tread carefully on these numbers. There are a few things that happen when you bring less than 20 percent for a down payment:
- You will be required to pay something called PMI (private mortgage insurance), which protects the lender in case you default on the mortgage. PMI varies in price but can easily add another $100 to your mortgage every month.
- The less you put up-front on the down payment means. But, on the other hand, the bigger your loan will be. Therefore, you’ll have more significant payments and more interest to pay over the life of the loan.
- Closing costs will also be higher. Generally, origination fees are one percent of the total loan.
So even though a low down payment may seem like a good idea, use caution. Try some numbers for yourself using a simple mortgage affordability calculator like Bankrate.
Raiding the Retirement Piggy Bank
We all know investing in retirement is essential, and although pulling money out of your retirement funds early isn’t really the best choice, it may interest you to know that it is an option. The IRS will allow first-time homebuyers to withdraw as much as $10,000 from their IRA to use towards their down payment.
Couples who both qualify can take out as much as $20,000. Unlike most early withdrawals, this one is penalty-free. However, you will still owe taxes on it when you file your return. Note that using your personal finance or taking out an FHA loan is better than using a private mortgage lender.
How Much Can You Borrow?
Figuring out your budget is only half of the battle. Next, it’s time for the banks to say how much money “they” think you should spend on a house.
Generally, your debt to income ratio helps you calculate how much house you can buy. It is determined by two ratios:
Rule of 28 – Maximum Mortgage Payment
This formula (also called the front-end ratio) says that your monthly mortgage payment should not exceed 28 percent of your gross monthly income. This figure should include your principal and interest payment and any money you’d also hold in escrow for other expenses such as property taxes, homeowners insurance, and PMI.
For example, if you earn $50,000 per year as pre tax income, then according to the bank, your total monthly mortgage payment should not exceed $1,400 per month.
Rule of 36 – Maximum Debt
This formula (also called the back-end ratio) says that your total monthly debt payments should not exceed 36 percent of your gross monthly income. This figure includes your (assumed) housing payment, credit card debt, auto loan, student loan, and even child support.
For example, if you earn $50,000 per year before taxes, then according to the bank, your overall debt should not exceed $1,800 per month.
How Strict Is the 28/36 Rule?
So if you don’t meet the 28/36 rules, will you automatically be disqualified from getting a mortgage?
In short, no. These are guidelines that most conventional loan lenders will use to access your creditworthiness, but they are not hard and fast rules.
In reality, many lenders will be willing to make exceptions if you’ve got a great credit score, bigger down payment than the 20%, and manageable forms of debt. Your chances are higher if you are completely debt-free. Also, buying a home with an FHA mortgage can bump you up to a 31/43 rule.
Other Important Considerations When Buying a House
There are a few other essential points you’ll want to consider as you’re trying to determine how much house you can afford:
Like it or not, your credit score will impact your ability to qualify for a home loan. But that’s not the only advantage. A high score will also help you qualify for the best possible mortgage interest rate. This is why it’s always in your best interest to regularly check your credit report and make sure your score is as high as possible.
Location and Taxes
Not all land is taxed the same, and it’s important to remember this as you’re shopping around for a house. For example, you might find the taxes near the city are significantly higher when compared to another home that’s only 10 miles away but outside the city limits. A lower tax bill will mean a lower overall mortgage payment.
Maybe the house you’d like to buy is in your price range but is going to require an additional $20,000 in renovations to bring it up to date. Alongside your down payment, this is yet another up-front cost you’re going to want to consider when looking at the big picture.
Mortgages aren’t free. Between the underwriting, appraisal, inspections, and various fees, the closing costs can add as much as 2 to 5 percent on top of your loan. So consider this when you’re estimating how much money you need to bring to the table at closing.
Alternatively, most lenders will try to simplify things by rolling the closing costs into the loan itself. However, that means a higher monthly payment and interest for the next 30 years on these expenses.
Finally, is your new house in a neighborhood that charges a monthly homeowner’s association (HOA) fee? In addition, you might be required by their bylaws to pay another $100 per month or so to maintain the neighborhood, roads, landscaping, etc. Be sure to ask the real estate agent since this is yet another expense that you’ll want to consider.
Conclusion: How Much Should You Spend on a Home
So far, we’ve covered all you need to know about buying a home. In summary, this includes knowing the home price, your debt obligations, down payment requirements, property tax rate, FHA loans, the minimum payments, etc. We also shared with you the mortgage calculator to use to avoid mistakes. Therefore, carefully consider all we’ve discussed before making that first down payment.