Sure, you’ve been saving up to buy a home for a while now, but when it comes down to it, how much house can you actually afford to buy? It's crucial that you be realistic about what you can manage, since purchasing a home is a long-term undertaking. It's a much bigger question than just how much money you have in the bank currently, or the total cost of the house — you'll need to consider things like potential renovations, your debt, taxes, and insurance. And what's the most important factor? All things mortgage.
Before starting to look at homes, use the Rocket Mortgage® Home Affordability Calculator to get a customized picture of what you can afford. Keep reading for our guide to being smart when it comes to managing your money during the home buying process.
Let's Talk Mortgage
There are several mortgage-specific factors that you need to think about when deciding on how much you can ultimately afford. First is the term, meaning the length of time you have to pay back the amount you’ve borrowed. The most common loan terms are 15 and 30 years, but there are other terms lengths available. The term will impact how much you'll be paying each month in your installments.
Let's take a look at some example numbers. If you buy a $200,000 house with a 15-year fixed-rate mortgage at 3.9 percent, your monthly payments are $1,469.37 (excluding taxes and insurance). Now, if we change the term so that you still buy the $200,000 house at 3.9 percent, but the term is 30 years, your monthly payments are $943.34 (excluding taxes and insurance). This is a pretty significant difference to consider. Reminder: This is just an example payment and many other factors can affect the type of rate you secure including your down payment and median credit score.
The next thing to noodle on is your mortgage interest rate, which is money collected over the entire life of the loan. The rate is determined by the lender, and can vary depending on your credit score, down payment, and other factors.
Beyond the actual numbers, you'll need to have a basic understanding of the different types of loans are available. A conventional mortgage is one that’s not guaranteed or insured by the federal government. In most cases, you’ll need a credit score of at least 620 and a debt-to-income ratio, or DTI (more on that later) of 50 percent or less.
A VA loan is a mortgage option available to United States veterans, service members and their (usually) non-remarried surviving spouses of those who passed in action or as a result of a service-connected disability. In order to qualify as a spouse, you need to be receiving Dependency Indemnity Compensation. An FHA loan is a loan that is backed by the Federal Housing Administration. If you have a lower credit score and less money for a down payment, you might qualify for an FHA loan.
How to Calculate Your Debt-to-Income Ratio
Your DTI is what mortgage lenders use to evaluate your mortgage application. Your DTI is a pretty good indicator of your ability to actually pay your mortgage, so it's what lenders use to calculate how much risk they're willing to take on. There's a simple way to figure out what your DTI is, it just takes a little bit of math and organization.
First, you'll need to add up all your monthly debts. This could include monthly rent or mortgage payments, student loan payments, car payments, monthly credit card minimum payments, and any other debts you might have. You don't need to add in bills that vary month to month. Think: groceries, utilities, or taxes.
Once you have that total, you'll divide it by your monthly gross income. Your gross income means what you're making before state and local taxes. So for example, if your debts add up to $2,000 per month and your monthly gross income is $6,000, your DTI ratio is 0.33, or 33 percent.
Think About the 29/41 Rule of Thumb
The general rule of thumb is that you want to keep your DTI ratio within the range of 29/41. This basically means that you want to make sure your mortgage payment (principal, interest, taxes, insurance and homeowners association dues) is no more than 29 percent of your gross monthly income, and that your total monthly debt (mortgage plus car loans, student debts, etc.) is no more than 41 percent of your total monthly income.
So how do you figure out that ratio? First, look at that 29 figure — this represents your housing expenses. You calculate it by dividing your mortgage payment (principal, interest, real estate taxes, homeowners insurance and if applicable, homeowners association dues and mortgage insurance) into your gross monthly income and converting to a percentage (multiply by 100).
The 41 figure is your total DTI after all your other debts are added up, including revolving debt (credit cards and other lines of credit) and installment debt (mortgage, car payment, student loans, etc.). You calculate this by using the following equation: installment debt plus revolving debt payments, divided by gross monthly income — then multiply by 100 to get a percentage.
All About Down Payments
How much you decide to put down for your down payment also impacts how much you'll be paying each month for your new home. Depending on your loan, you could put as little as 3 percent of the purchase price down (or 0 down if you qualify for certain government-backed loans) — or you could decide to put down a larger percentage. Certain properties, like apartment buildings or condos, might require a higher down payment.
However, there are some advantages to putting down a larger down payment, namely a lower interest rate. The higher your down payment is, the better your interest rate will be. If a lender doesn’t have to give you as much money, they're more likely to take on the investment.
If you put down more than 20 percent, you won't have to pay for mortgage insurance. Mortgage insurance, which protects your lender and the mortgage investor if you don’t make payments, can involve a monthly fee as well as an upfront fee depending on your loan option.
Don't Forget About These Extra Costs
Unfortunately, buying a home isn't as simple as just paying for the home itself — there are also some costs associated with the overall process as well as maintaining the home that you should think about. Before buying a home, it's smart to contact a homeowners insurance agent to get a quote on what your rate could be — it depends on where you live, your neighborhood, and the type of home you buy, as well as the value of your property, potential rebuild costs, and the value of your at-risk assets.
Depending on where you live, you'll likely need to consider what your property taxes will be. You can ask your local tax assessor for more information.
And the last step in the home buying process is paying your closing costs. These include the loan origination fee, appraisal fees, title search fees, credit report charges, and more. Your lender can giver you an estimate of your closing costs, but usually closing costs can land anywhere from 3 percent to 6 percent.
Finally, the most important thing to consider is your future. Do you feel like you will be employed with a steady, predictable income for the forseeable future? Do you have an emergency fund for any unexpected life events? Are you planning any large milestones that might take on a good chunk of your monthly expenses (like a wedding, having a baby, or retirement)? The big picture is the best picture when heading out into the world of purchasing a home.