By Wendy Mihm | February 14, 2011
Whether you’re buying your first house or considering upgrading to a larger home, many people start with the basic question “How much home can I afford?”
Home Affordability Rule of Thumb
There is a rule of thumb that you can apply, and we could theoretically end this post right now. Here’s how it goes: most of us can afford a home that costs about three times the amount of their total annual household income. Here’s what it looks like as a math problem:
(Your annual salary + your spouses annual salary) x 3 = price of home
That assumes two key things: first, that you and your spouse are able to make a 20% down payment on the house and second, that you are carrying only a moderate amount of other debt, such as student loan or credit card debt.
We will not end this post there, since a rule of thumb is rarely enough for most of us, and because it’s also important to know the upper limit of what you can stretch to. Why? Because if you are looking to buy your next home and not your “starter” first home, you may be planning to raise your family and stay in that home for the long haul. For this reason, you may be looking to stretch a bit. If all goes as planned, your income(s) may grow as your career(s) do, and house payments that are a stretch now may not seem so difficult 5, 10 or 15 years from now.
Of course, in doing so you don’t want to get yourself into too large a loan and end up not being able to make the monthly payments. We heard that story too many times during the Great Recession and don’t want to re-learn that lesson. In finding the right size loan, you will be looking to strike a balance between stretching to find a home that will suit your family for the long haul, and staying within a limit that will remain financially achievable.
So let’s look again with a new lens, and figure out what your responsible upper limit could be.
Simply put, the upper limit on the amount of home you can afford is:
The dollar amount of your down payment + the largest loan for which you qualify = price of home
You and your spouse are in charge of the first part of the equation in that you determine the size of your down payment. If you are buying your first home, you will need to save money for quite awhile, as the magic number to reach is 20% of the price of the home. And when homes are as expensive as they currently are in many areas, 20% of a home price can be a big number.
20% Down Payment is Key
But having a 20% down payment will give you the most power as a buyer. First, it will help you to qualify for a loan, and that loan will likely be at a better interest rate. Second, it will keep you from paying private mortgage insurance (PMI), which is just money paid to the bank to compensate them for the possible risk of default on the loan. If you have to pay PMI, it gets tacked onto your monthly mortgage payments, so if you can avoid that extra expense, it’s a great savings.
The lender, often a bank or other financial institution, will decide the second part of the equation, the size of the loan. In doing so, they evaluate your household’s income sources, debt, credit score and down payment to decide how risky it will be to loan you money. Then they decide on a loan amount and an interest rate and voila! That is the dollar amount that you enter into the second part of the equation.
If you have purchased a home before, you are familiar with this exercise, but if it is your first home, you may also be familiar with this type of scrutiny from past landlords.
Regardless, it is good to know before you start seriously shopping for a house, how much home you can really afford. That way you can get pre qualified for a loan and, when you find the right home, you’ll be ready to put in a bid.
Below is a calculator to get you started. The thinking is a bit different from what we discussed above, but it lets you play around with house prices, so it’s pretty fun that way. Here’s how it works:
Plug in the price of a house you found (or any price you think would be a good stretch price for you).
Plug in information about a loan you could reasonably expect to get. Just take your best guess about interest rates and loan lengths. Common fixed rate lengths are 15, 20 and 30 years. A quick Google search for interest rates will get you a zillion results. It then asks for your “front and back ratios.” The calculator has already entered mid-level values for these ratios, so to keep things simple, you can leave these values as-is. But in case you want to know, front and back ratios are just percentages that are supposed to help you limit your housing and necessary living spending. A front ratio is a percentage of your gross income that you will allow yourself to spend on all housing related expenses, including property taxes and insurance. A Back ratio is a percentage of your gross income that you will allow yourself to spend on your housing expenses plus cost of shelter: food, clothes, gas, etc. Front / back ratios with values of 28-33 / 36-42 considered conservative. Values bigger than 35 / 45 are considered aggressive and are not recommended for use.
Plug in information about the annual property taxes where you plan to buy the house (you should be able to Google that too), insurance on the house, and PMI (remember, if you’re putting down 20% you can enter 0 for this).
Play around a bit—have some fun with it! I find that daydreaming about our next home can be a lot of fun, and it’s even more fun when you can realistically answer the question “How much home can I afford?
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