House hunting is a bit like dating. Sometimes, you fall for the wrong person – or the wrong house. It’s not at all unusual to fall head over heels in love with a house that’s way out of your budget. You feel like you just have to have it, so you pull every string you can to get approved for a bigger mortgage.
But once you’re settled into your new, beautiful home, you discover that you can’t relax and enjoy it. You’re too busy struggling to make those high monthly mortgage payments. You have no money left for fun, and you’re constantly stressed about paying all your bills. That’s when the romance turns sour.
To avoid being caught in this kind of bad relationship, you have to plan ahead. Before you start shopping, figure out how much house you can afford. Then make sure you stay within your home-buying budget by refusing to look at anything outside your price range. That way, you won’t risk being swept off your feet by a house that will only break your heart.
The Dangers of Buying Too Much House
When you buy more house than you can afford, you’re not just putting your financial future at risk. You’re also sacrificing your happiness in the here and now. Here are some of the problems that come with an overpriced house:
- Being House Poor. Being house poor means you devote so much of your income to your monthly house payment that there’s nothing left to spare. You’re surrounded by gorgeous hardwood and marble, but you’re broke. The joy of living in an exquisite four-bedroom Colonial fades quickly when you can never afford to leave it, because even a movie or a dinner out is too much for your budget.
- Living on the Edge. When you’re stretching to make your mortgage payment each month, there’s no wiggle room in your budget. If you suffer a sudden drop in income – say, because your work hours get cut – you won’t be able to afford the payments at all. The same thing could happen if your expenses increase due to health problems or plain old inflation. That means just one small setback could cost you your home.
- Risk of Rising Payments. The risk that you won’t be able to meet your mortgage payment is even greater if you have an adjustable rate mortgage (ARM). ARMs offer a low initial rate, which makes it look like your monthly payment should be easy to manage. However, that low rate is only good for a few years. After that, your payment jumps to a level based on current interest rates. If you can’t afford the new, higher payment, you have to refinance or lose the house. This is what happened to a lot of buyers in the mortgage crisis of 2008.
- Money Stress. If you’re lucky, problems like these won’t come up. But even if they don’t, just knowing they could may be a constant source of stress. Living with this kind of stress every day can harm your health and your relationships. It can lead to lost sleep, increased blood pressure, and even heart disease and stroke. It can also make you depressed and irritable with friends and family.
- Sacrificing Savings. When every spare penny is going toward your mortgage, it leaves you nothing for savings. You can no longer afford to set aside money for retirement or save for your child’s college education. For the sake of having a comfortable home right now, you’re risking your whole financial future – and your children’s.
Determining What You Can Afford
It’s tempting to assume that the easiest way to figure out how much house you can afford is to ask your mortgage lender. After all, you figure, they’re the experts. If they say you qualify for a $300,000 loan, that must mean you can afford a $300,000 mortgage.
Unfortunately, mortgage lenders aren’t the best people to ask. They make their money by making loans, so it’s in their interest to get you to take out as big a loan as possible. To do this, they can juggle all kinds of figures – interest, points, income – to come up with a monthly payment that just fits into your budget. If you have to stretch every month to make your house payment, well, that’s not their problem, as long as you keep making it.
This isn’t to say that all mortgage lenders are dishonest. Most of them aren’t setting out to trick you into a loan you can’t afford – at least not on purpose. But they still have every reason to encourage you to borrow as much as you can. Also, they just don’t know as much about your financial situation as you do.
That’s why it pays to double check the bank’s figures by doing the math yourself. Look at your finances, crunch the numbers, and come up with a payment that fits easily into your budget – not one you’ll be struggling to meet.
Debt to Income Ratio
All lenders use the same basic formula to figure out how much house you can afford. It’s called a debt-to-income ratio, or DTI. This is the percentage of your monthly income that goes toward paying all your debts, including your mortgage.
Here’s an example. Lou and Christy have a combined monthly income of $7,400. Out of this, they pay:
- Student loan for Lou: $600 per month
- Student loan for Christy: $600 per month
- Car loan: $300 per month
- Minimum payments on Lou’s credit card: $200 per month
- Minimum payments on Christy’s credit card: $150 per month
- Total debt payments: $1,850 per month
However, if they add a monthly mortgage payment of $1,500, their total debt payment rises to $3,350. That would bump their DTI up to more than 45%. In other words, nearly half their income each month would be going toward their debts. Most banks would agree that’s way too much, so Lou and Christy probably would not qualify for this mortgage loan. Dividing their total debt by their $7,400 income, their DTI right now is 25%.
However, if they pay off some of their other debts, things look brighter. For instance, if they can pay off one of their student loans, that would drop their total debt to $2,750 a month, for a 37% DTI. Paying off both student loans would drop their debt to $2,150 a month and their DTI to 29%. That’s an amount most banks would approve.
Find an Affordable Payment
To figure out how much house you can afford, banks calculate your DTI in two different ways. First, they look at what they call the “front-end ratio.” This is the amount of your income that your monthly housing payment – principal, interest, taxes, and insurance – would take up all by itself.
The usual rule is that your payment should not come to more than 28% of your total income. For example, look at Lou and Christy. Their monthly income is $7,400, and 28% of that is $2,072. That’s the maximum they could spend on a house payment if they had no other debts.
However, Lou and Christy do have other debts, which also eat into their income. To account for those, banks use the “back-end ratio.” This is the amount of your income that goes toward all your debts combined.
Most banks say this total should not add up to more than 36% of your total income. For Lou and Christy, that amount would be $2,664 per month. However, their other debts already cost them $1,850 per month. That leaves only $814 per month for them to spend on their mortgage.
Luckily for them, there’s a loophole. Banks are often willing to stretch the back-end ratio to as much as 43% for “qualified mortgages.” These are mortgages that meet certain rules that make them easier to pay. For example, they cannot be balloon mortgages or loans with an interest-only period.
Using this rule, Lou and Christy could pay up to $3,182 a month on all their debts. Minus the $1,850 they pay now, that leaves them $1,332 per month for a house payment.
Factors to Consider
Even if you can qualify for a loan that gives you a 43% DTI, that doesn’t mean it’s a good idea. If you devote this much of your monthly income to debt, you’ll only have 57% left to cover all your other needs. You need to figure out if this is enough to live on before making a decision.
To determine what you can afford, consider these factors:
- Monthly Income. The first thing you need to know is exactly how much money you bring in each month. This includes your salary and any other sources of income, such as investments. Your total income is the baseline for figuring out how much you can afford to pay for housing each month.
- Debt Payments. If you have existing debts, then part of your monthly income is already spoken for. Figure out how much you need to spend per month to service any other debts you have, such as student loans, car loans, or credit card debt.
- Other Expenses. Of course, debt payments aren’t your only expense. You also need to cover other needs like food, utilities, childcare, and transportation. Lenders usually don’t ask about these expenses when considering you for a loan. They don’t know whether you are spending a lot to send your children to a private school, or saving a lot by living without a car. This is something you’ll need to figure out for yourself. Look at your household budget and figure out how much of your monthly spending goes toward necessities you can’t cut. If you don’t have a budget, this is a good time to make one, since you’ll probably need it as a homeowner.
- Savings. A final monthly expense is money you want to save. For instance, if you’re setting aside $250 per month to save for retirement or fund a college savings plan for your kids, that’s another chunk of your income that you can’t put toward housing.
- Available Funds. Affording a house isn’t just a matter of meeting the monthly payments. You also need to have enough cash on hand to cover the down payment and closing costs. The amount you pay up front will also affect the monthly payments. If you can afford a large down payment, you won’t need to borrow as much for your mortgage, which will lower your monthly payments. On the other hand, if the amount you have saved up isn’t enough for a down payment of at least 20%, you will probably have to pay for private mortgage insurance (PMI). That will add between $50 and $200 to your monthly payment. Look at all your available funds, such as savings and investments, and figure out how much you can spare to put toward your house purchase.
- Credit Rating. Finally, you need to consider your credit score. If you have very good or excellent credit – that is, a FICO score of at least 750 – you will qualify for the best interest rates on your mortgage, which will keep your monthly payments low. On the other hand, if you have fair to poor credit – no better than 700 – you are likely to pay higher rates, raising your payments. If you don’t know how good your credit is, there are several ways to check your credit score for free.
As you can see, there are a lot of factors that affect your monthly house payment. Trying to add them all up and figure out what you can afford can be incredibly complicated. At some point in the process, it’s tempting to throw up your hands and decide to go with the bank’s estimate after all.
Fortunately, you don’t have to do all this math yourself. There are lots of affordability calculators online that can do it for you. All you have to do is punch in some information about yourself, such as your income, debts, and down payment. Then the calculator crunches the numbers and tells you how much house you can afford.
One of my favorite calculators is from Zillow. The affordability calculator at Zillow has two versions:
- The quick and easy version asks for three numbers – income, debts, and down payment – and spits out a maximum home price.
- For a more precise estimate, you can click on “advanced” and enter details about loan terms. Unlike the other calculators, this one also lets you adjust the target DTI. Instead of relying on the standard figure of 36%, you can set the DTI to whatever share of your income you’re comfortable spending on housing. The lower you set this figure, the more confident you can be that your new house will fit easily into your budget.
Getting Ready to Buy
In some cases, seeing how much house you can afford is a rude awakening. It can even be depressing if the total is so low that there’s just nothing in your area that fits into your price range.
Fortunately, there are ways around that problem. If you set your financial house in order before you start house-hunting, you can stretch your budget to cover a lot more house. Here are a few steps to take.
1. Build an Emergency Fund
First, make sure you build up an emergency fund. Owning a home is expensive – and unpredictable. You never know when your roof is going to start leaking or your water heater is going to give up the ghost. Without a cash cushion, you’ll have to rely on credit to pay for big repairs like this, which will put more strain on your budget.
An emergency fund can also be a huge help if you suddenly lose your job or have your hours cut. With plenty of cash on hand, you’ll still be able to make your payments, so you won’t lose the home you worked so hard to buy.
Experts say you should have enough money in your emergency fund to cover at least six months’ worth of living expenses. If you don’t have that much, you’re not ready to buy a house yet. Start setting aside a little each month to build up your nest egg, and wait until it reaches full size to start shopping for a home.
2. Make a Down Payment
Along with your emergency savings, you need to save up for a down payment – the bigger, the better. The more cash you can put down up front, the less you’ll have to spend on your monthly payments.
Ideally, you want to put down at least 20% of the cost of the house so you won’t have to pay PMI. So, if you want to buy a house that’s worth $200,000, you should aim to have $40,000 for your down payment.
If you’re nowhere close to that amount yet, you need to start funneling all the spare cash you can into your house fund. Start by skimming off some of your paycheck each month – before you even cash it – and put that into the fund. On top of that, save all the extra cash windfalls that come your way: a tax refund, a performance bonus, even the cash back savings from your credit card. Over time, it all adds up.
3. Clean Up Your Credit
The higher your credit score is, the better the terms you can get on your mortgage. If your credit is only so-so, boosting it into the good or very good range can help you get a loan you can afford.
There are several ways to improve your credit score:
- Pay Your Bills On Time. The biggest factor in your credit score is whether you pay your bills on time. Having just a few late payments can seriously mess up your score. To make sure this doesn’t happen to you, set up payment reminders in your online banking account. The bank will send you a notice whenever you have a bill coming due in a few days. Or, easier still, use an automatic bill payment plan to pay your bill as soon as you receive it.
- Pay Down Debt. Having a high debt load hurts your credit score. That’s because the more debt you’re already carrying, the more likely you are to have trouble paying off new debts. Paying off old debts, or paying down their balances, will improve your credit score. As a bonus, it will also free up extra cash for your house payment.
- Raise Your Credit Limits. Although borrowing more money hurts your credit score, being able to borrow more money helps it. Say you have a maxed-out credit card with a $1,000 limit. If you raise the limit to $3,000, your total debt hasn’t changed, but now you’re using only 33% of your available credit. This means you’re no longer skirting close to the financial edge, so your score improves.
- Pay Bills More Often. Even if you pay your bills in full every month, your credit report doesn’t show a $0 balance. Instead, it says you owe the amount on your last monthly bill. So, if you charge $1,000 a month and pay it all off, it still looks like you’re carrying $1,000 in debt. However, if you pay half your bill early, the amount on the bill when you get it will only be $500. It looks like you’ve cut your debt in half – and it doesn’t cost you a penny extra.
4. Pay Off Other Debts
As you can see from Lou and Christy, the more debts you have, the harder it is to afford a mortgage. Paying off old debts, such as a student loan or a car loan, leaves more money free for your monthly house payment. It also improves your chances of qualifying for a loan with good terms.
There are several different methods for paying off old debts:
- Debt Snowball. With this method, you set aside a certain sum each month and put it all toward your smallest loan balance. Focusing on your smallest debt first helps you pay it off quickly, boosting your morale. Once it’s gone, you can take all the money you used to put toward that debt each month and throw it at the next smallest debt. Over time, the amount you put toward your debt will grow and grow, and your debts will disappear one by one.
- Debt Avalanche. This method works much like the debt snowball, but you focus on your highest interest loan first. High-interest debt costs you the most money every month, so paying it off first helps you knock down your total debt faster.
- Debt Snowflaking. If you don’t have enough room in your budget to put a fixed sum toward paying off debt each month, you can still pare down your debts through debt snowflaking. This means taking whatever small sums you can set aside each month, from a tax refund to a $10 coupon savings, and putting them toward your debt. Over time, even little payments like these add up. You can also combine snowflaking with either the snowball or avalanche method, adding in these small sums on top of your regular monthly payment.
- Refinancing. If you have high-interest debt, you can pay it off faster by refinancing it at a lower rate. For instance, you can use a balance transfer for high-interest credit card debt or take out a debt consolidation loan. Spending less on interest means more of your monthly payment goes toward principal, so your debt shrinks faster. However, there’s a fee for refinancing debt, so it probably isn’t worth doing if the monthly savings is small.
If you manage to pay off all your old debts, you can convert your debt snowball to a savings snowball. Just take the monthly sum you used to pay on your debt and start saving it up for your down payment. You can go from watching your debt shrink to watching your down payment grow month by month.
5. Look for Special Deals
If you’re on a tight budget, consider programs that can help you get a good deal on a mortgage. Many state governments offer special discounts for first-time homebuyers. You can also get deals based on your income, your job, or where you live. Visit HSH.com to find programs in your state.
There are also programs that can help you afford a down payment. For instance, the National Homebuyers Fund makes grants to low- and middle-income buyers through its Down Payment Assistance Program. Specific states also offer programs to help buyers with their down payments. To find one, do a search for “down payment assistance” with the name of your state.
The bottom line for home buyers is, don’t overstretch yourself. Maybe you could buy that “dream home” if you drained your savings account and squeezed every last penny out of your monthly budget. But if your finances change, that dream could turn into a nightmare.
It makes more sense to leave a bit of breathing room in your budget. That way, if food or fuel prices go up, it won’t stretch your budget to the breaking point. If you run into a major expense, such as replacing your furnace, you’ll have the money to pay for it. And if you lose your job or part of your income, you won’t necessarily lose your home as well.
Finding the right house, like finding the right spouse, takes time. It’s easy to be seduced by good looks and ignore all the drawbacks that go with them. But it’s worth holding out for a home that fits both you and your budget. A house you can afford is a house you can truly live happily ever after with.
Have you ever fallen for an unaffordable home? Or did you hold out for something in your price range?