Are you looking to buy your first or next home? Figuring out how much you should spend on a house is a major decision. And how you handle it will have an impact on your finances for years to come.
Several factors affect how much house you can afford including your credit, income, how much you decide to spend on your down payment, and your level of expenses.
In this article, we examine several tips that can help you determine how much to spend on a house and avoid overextending your finances.
Determining how much should you spend on a house
According to the latest Bureau of Labor Statistics’s Consumer Expenditure Survey, housing takes up about 33% of consumer’s annual spend, which includes mortgage payments.
That’s a big percentage. Housing is, in fact, the largest component of people’s annual expenditures. That’s why figuring out how much home you can afford is so important.
While the first home affordability tip below seems conservative, keep in mind that it doesn’t consider whether you have student debt or any other types of debt. Everyone’s situation is different, but if you’re carrying debt, being conservative is a smart move.
Your monthly housing costs shouldn’t exceed 28%
Mortgage lenders have several ways to determine how much house you can afford. One of them is the 28% rule. The rule states that your monthly housing costs shouldn’t exceed 28% of your gross monthly income.
This means that taken together, your mortgage payment, insurance, property taxes and applicable HOA fees should represent less than 28% of your monthly income before taxes and other deductions. Find out the cap on how much you can spend on housing each month by multiplying your gross monthly income by 28%.
For example, if your gross income is $60K the 28% rule implies that your monthly housing expenses shouldn’t go over $1,400 ($60K / 12 x 0.28), including mortgage payments.
Here’s the maximum you should spend on a house according to the 28% rule:
| Annual Gross Income | 28% Rule Monthly Housing Limit |
|---|---|
| 50K | 1,167 |
| 55K | 1,283 |
| 60K | 1,400 |
| 65K | 1,517 |
| 70K | 1,633 |
| 80K | 1,867 |
| 90K | 2,100 |
| 100K | 2,333 |
Your debt-to-income ratio shouldn’t be more than 36%
Another metric used by lenders when evaluating how much mortgage you can afford is the 36% rule. This rule states that your total monthly debt payments shouldn’t exceed 36% of your gross income.
These monthly payments include student debt payments, credit card payments and other fixed expenses. And lenders use these figures to determine your debt-to-income (DTI) ratio. The ratio is calculated by dividing your total monthly debt payments by your gross income.
Your DTI ratio tells lenders whether you have enough slack to afford your mortgage. With a low ratio, they can get reasonably comfortable that you’ll be able to handle your mortgage payments when due. And it helps lenders determine how much mortgage you really can afford according to their internal standards.
Keep in mind, your DTI ratio is only a factor used to figure out how much mortgage you can qualify for. So even if your DTI ratio exceeds 36% you may still get approved for a mortgage: for example, if your down payment is large enough and you have a good credit score.
Have you saved enough for a down payment?
The thought might have crossed your mind: How much should you spend on a house down payment? It’s an important question to ask. Lenders require an upfront down payment of between 5 and 20% to extend you a mortgage for your new home.
How much mortgage you can handle will depend on your down payment amount. In most cases, if your down payment is less than 20%, banks, credit unions and mortgage brokers will require private mortgage insurance (PMI) on your loan.
PMI can run between 0.25% to 2% of your original loan amount each year. And since this would get added to your monthly payment, it can make your mortgage less affordable. So saving consistently for your down payment can help you afford more house or make your mortgage more affordable.
A good credit history can help you get the best rate for your loan
Your credit score plays an important role in determining your mortgage rate and how much house you can buy. In fact, some lenders may only focus on applicants with good to very good credit ranges, offering their better rates to those meeting high cutoffs.
Having a good credit history can open the doors to lenders’ lower rates and help you get a mortgage you can afford. But if your credit score is below 600, you may not qualify for a conventional mortgage.
Still, you may qualify for other loans. Loans backed by the Federal Housing Administration (FHA), for example, are a good option for first-time home buyers. These loans have less demanding FICO score requirements and require down payments between 3.5% and 10% depending on your credit history.
If you don’t qualify for a mortgage because your score is too low, take the necessary steps to improve your credit score before you re-apply. It might take several months, but you can do it on your own for free, or pay someone to repair your credit, if needed.
Calculate the mortgage you can afford
Now that you have a better sense of the kind of monthly mortgage payment you can afford, how do you figure out how much house you can actually buy?
Consider the following example. Let’s start by assuming that you’re looking for a 30 year mortgage rate. The table below lists the monthly mortgage payment per $100,000 borrowed for a given 30 year rate.
| 30 Year Mortgage Rate | Monthly Payment Per $100,000 |
|---|---|
| 3.50% | $449 |
| 4.00% | $477 |
| 4.50% | $507 |
| 5.00% | $537 |
| 5.50% | $568 |
| 6.00% | $600 |
Next, use the 28% monthly housing limit table of the prior section and look up the maximum monthly housing cost implied by your annual income. As an example, assume the following:
- An annual income of $60K
- A 5.00% 30 year mortgage rate and
- $300 a month in property taxes and insurance
Under these assumptions, the 28% rule table implies a maximum monthly housing cost of $1,400 a month. And a 5.00% rate implies a payment of $537 a month for every $100,000.
After subtracting the $300 a month in property taxes and insurance, you’re left with $1,100. By dividing $1,100 by $537 (the cost to borrow $100K), you get 2.05. This implies a loan of 2.05 x $100,000 = $205,000.
The $205K plus your down payment will give you a good idea of the amount you could spend on a house. Other affordability calculators will give you slightly different values depending on the assumptions behind them.
Finally, don’t forget to include your closing costs when estimating the mortgage you can afford. Closing costs vary widely depending on where you live, but are typically in the range of 2.5% to 5% of your home’s purchase price.